Public Policy: Using Market-Based Approaches - Department for ...

Section 7 – Market-Based Mechanisms
● Increasing the length of the contract term reduces the number of times the
contract is re-tendered and competition takes place. If this means that
opportunities to win a contract are rare, it could force unsuccessful firms to
exit, reducing competition for future tenders. On the other hand, a longer
contract term may in fact increase competition for each tender because it
makes each contract potentially more profitable and therefore may
encourage more firms to bid.
● The terms of the contract can also affect the incentives to bid. A fixed-price
contract will be desirable in one sense, because it transfers risk (the risk that
costs might increase, for example) to the service provider who then has an
incentive to manage and minimise these risks (keep costs under control, for
example). However, transferring this risk to the provider also reduces their
incentive to participate. Therefore, if there is concern over a lack of competition,
it may be desirable to reduce the extent to which risk is transferred to the
service provider (by the use of some element of cost-plus pricing).
● One factor that might favour an incumbent is the switching costs that would
be incurred by the public sector when switching providers. If the public sector
commits to ignore these switching costs this might encourage other firms to
bid. This would be sensible if the gains from encouraging competition are
expected to outweigh the additional switching costs that might be incurred.
Second, problems of market power can occur if there is collusion between
potential bidders. This might involve an agreement over which tenders will be
won by which firms, with other firms not bidding or bidding at high prices in
order to avoid winning the tender. The nature of public procurement means that
it is often susceptible to such collusive behaviour. For example, potential bidders
will often have to meet certain criteria which limit the number of potential
bidders and create barriers to entry for new participants. There is also likely to
be transparency over the contracts that are available and who has won each
contract, which helps firms to monitor whether competitors are complying with
their collusive agreement.
It may be possible to reduce the risks of collusion by addressing these factors:
reducing any qualifying criteria for participants and reducing transparency over
tender outcomes. However, this might not be possible: qualifying criteria may be
important to maintain service quality, for example.
It may also be possible to reduce the risks of collusion through the choice of
auction design. For example, a sealed-bid auction (where participants submit
their bids simultaneously in one round of bidding) will reduce transparency
compared to an open auction (where participants are invited to make bids at a
specified price which is then raised or lowered, depending on the type of
auction). A sealed-bid auction may reduce efficiency but this might be
considered acceptable where the risk of collusion would otherwise be high. Part
V contains information on how open auction design can be tailored to minimise
the risks of collusion.
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