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Public Policy: Using Market-Based Approaches Risk-sharing When the government has less information than the supplier, it may be forced to trade-off risk allocation and performance incentives. Principal-agent theory tells us that the principal (the government) is often unable to distinguish between the effects of an agent’s (the service provider’s) effort and random events on output. Transferring the risk of an unfavourable outcome to the private sector requires that the private-sector firm be compensated for this burden, leading to higher procurement costs. However, if the government accepts the full burden of risk, the private sector provider may be faced with inappropriate incentives. Different forms of contract strike a different balance in this trade-off. Fixed-price contracts provide strong incentives for productive efficiency, as an agent is rewarded for any cost-reducing effort he makes (Laffont and Tirole, 1993). However, they suffer from weak quality incentives as the agent can increase profit by reducing quality, particularly where quality is difficult to measure or observe (Holmstrom and Milgrom (1991); Hart, Shleifer and Vishney (1997)). 203 Cost-plus-fixed-fee contracts offer weak incentives for productive efficiency, and may encourage ‘gold plating’ in which the supplier produces the highest possible quality as it is compensated for any effort it makes. Incentive contracts involve a fixed-fee component as well as a pre-determined fraction of costs incurred. For incentive contracts to achieve their desired outcomes, there must be both accountability and enforceability (see Stiglitz, 2000). Winner’s curse Winner’s curse arises in common-value auctions, in which competing bidders have different information about the value of the tender. The winner’s curse effect refers to the adverse selection problem that arises because the winner tends to be the bidder with the most optimistic valuation of the tender. As the probability of over-estimating the tender value increases with the number of competitors, bidders are aware of this and internalise the winner’s curse problem by bidding more cautiously. This leads to the perverse result that increasing the number of competitors can actually increase procurement costs. The more information a bidder has, the smaller the chance of falling prey to winner’s curse and the more aggressively bidders will therefore bid. Choosing an auction design to maximise information, such as the open auction, helps mitigate this problem as it reduces the probability that a bidder will have overestimated the value of the good. 204 However, it should be noted that increasing the availability of information may substantially increase the costs of the tendering process. 203 Holmstrom, B. and Milgrom, P. (1991) ‘Multi-Task Principal-Agent Analyses: Incentive Contracts, Asset Ownership and Job Design.’ Journal of Law, Economics and Organisation 7. 204 Salmon, T. 2004’Preventing Collusion’ Chapter 3 in Auctioning Public Assets: Analysis and Alternatives. Ed. M. Janssen. Cambridge University Press.. 182
Empirical evidence on winner’s curse Flambard et al (2004) analyse snow removal contracts tendered by the City of Montreal under an independent, private-value procurement auction model. 205 They find a positive correlation between costs and bids, that rents increase with the variance of costs and that rents decrease with the number of bidders. Their findings suggest that rationalising tender requirements may permit economies of scale to be reaped and technological progress to be induced without too great a cost in terms of impact on competition. There is some empirical evidence suggesting that the winner’s curse exists, although the risk is mainly for the firms bidding, rather than for the government agency. However, where the winner’s curse effect is particularly strong, this can deter bidders and so can raise the total cost of procurement. Hong and Shum (2001) evaluate the effect of increased competition on equilibrium bidding in procurement auctions using data from the New Jersey transport department. 206 They demonstrate that the response of procurement costs to increased competition depends on the relative magnitude of the competitive and winner’s curse effect, which in turn depend upon the relative importance of the private and common value elements of the bid. They observe that when the asymmetric information, and thus winner’s curse effect, is particularly severe, authorities may gain from allowing collusion amongst bidders. Discussions between competitors may give rise to information pooling that prevents the winner’s curse from arising and thus leads to lower procurement costs. TRANSACTIONS COSTS Section 12 – Issues in the implementation of market mechanisms Theory and empirical evidence shows us that sometimes market-based mechanisms may be more costly to implement than the benefits they yield. The procurement process itself is often very costly, and design features to limit the extent of its potential pitfalls may increase these costs still further. For example, tendering contracts more frequently and splitting up requirements over multiple suppliers reduces incumbency advantages, but also implies greater tender costs. Specifying all aspects of service quality and monitoring and enforcing the resulting contract is similarly costly, as is increasing the availability of information to reduce the likelihood of a winner’s curse outcome. However, theory also provides some guidance about (a) how to minimise these costs and (b) when a market-based mechanism is likely to be most appropriate given the identified costs and benefits. As Domberger and Jensen (1997) note, the costs of contracting can limit the practical application of procurement. Williamson (1979) shows that the cost of transacting in the marketplace can be large enough to offset the benefits, in which case in-house production would be optimal. Whilst this theory was 205 Flambard, V., Lasserre, P., Mohnen, P. 2004. Snow removal auctions in Montreal: costs, informational rents, and procurement management. 206 Hong, H. and M. Shum. Increasing competition and the winner’s curse: evidence from procurement. 2001. 183
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DTI ECONOMICS PAPER NO.14 Public Po
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DTI ECONOMICS PAPER NO.14 Public Po
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Contents Acknowledgements vi Forewo
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Contents Section 11 Emissions Tradi
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Foreword There is increasing intere
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SECTION 1 Introduction and summary
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Public Policy: Using Market-Based A
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SECTION 2 Using market mechanisms U
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SECTION 3 Lessons for the design an
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SECTION 4 Introduction This part of
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SECTION 7 Market-Based Mechanisms W
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SECTION 8 Framework for assessing m
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Part IV Case Studies 73
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● the Green and White papers behi
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A prison failing to deliver on its
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Table 9.3 Companies providing priso
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Section 9 - Competitive Tendering o
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detect any deviation from a collusi
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at HMPS began as an equal mix of th
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(e.g. lighting). This impact could
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MARKET POWER The full benefits of c
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However, it should be noted that te
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on competition is uncertain. The ab
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Controlling for problems of asymmet
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Procurement process design One way
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however, financial deductions are m
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The Independent Monitoring Board at
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Figure 9.1: Difference between the
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‘While there were staff in the pu
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design the invitation to tender and
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and demand conditions. Second, we d
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DEMAND Anyone can apply to a local
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● Rent deposit guarantee by the l
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The Green Paper stated the Governme
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It was not an objective of ODPM or
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DESCRIPTION OF MARKET MECHANISM The
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Once the outcome is determined, fee
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DEVELOPMENTS OVER TIME The major mo
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Concerns about capacity constraints
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