4. Incentives and transaction costs in public procurement Steven Tadelis INTRODUCTION Standardized goods, such as computers, office supy and automobiles are mass produced, have standard characteristics and are typically pur- chased at list price from a menu of prespecified characteristics. Custom made goods, such as new buildings, custom-software or legal services are tailored to fit a buyer's specific iad often unique needs. To procure these customized goods, the buyer usually hires a contractor who supplies the good or service according to a set of desired specifications, referred to as the procurement problem. The procurement problem has attracted much attention both in policy in academic circles. The main focus of academic economists has been on procurement by the public sector, in part because of its sheer impor- tance to the economy. For example, procurement by federal, state local government accounts for more than 10 percent of gross domestic product in the United States. When considering the procurement of goods and services, the buyer is faced with many challenges. First, she has to choose what exactly should be procured, how to transmit her needs to the potential suppliers. Second, a contract must be laid out that includes contractual obligations methods of compensation. Third, the buyer needs to decide how to award the procurement contract between the potential suppliers. Finally, the award mechanism should result in the selection of a qualified and desir- able supplier and in the implementation of a cost-effective final product. Procurement is often achieved with the buyer seeking, through competi- live bidding, a low to purchase the desired good or service. To achieve this low , competitive bidding is widely recognized as an attrac- live award mechanism is commonly advocated for several reasons. Most notably it is viewed as a procedure that stimulates and promotes competition. By their nature, open competitive bidding procedures invite potential suppliers from many venues, fair market discovery is oF68 Regulation, deregulation, reregulation often touted as a beneficial result of such bidding. Such award mechanisms are also known for their transparency, making it easier to prevent corrup- tion in the public sector where procurement agents may have incentives to rig the system in return for bribes and other benefits. These characteristics, as well as arguments for equal opportunity, provide a justification for statutes such as the Federal Acquisition Regulations (FARs) that strongly favor the use of auctions in the US public sector. Interestingly, in the private sector there is widespread use of both competitive bidding for fixed-price (or unit-priced) contracts, and of negotiations. Many negotiated contracts are cost-plus contracts that are negotiated with one potential supplier who is selected before the contractual arrangements are in place. For example, Bajari et a/. (2007) show that from 1995 to 2000, 44 percent of private sector non-residential building construction projects in Northern California were procured using negotiations, while only 18 percent were procured using open competi- tive bidding. The use of negotiations with single source suppliers is also common in high-tech and software, and used for defence procurement as well. This chapter offers a framework to compare competitive bidding for fixed-price contracts. with negotiations over cost-plus contracts. Most of the existing formal economic analysis describes the procure- ment problem as follows. The supplier has information about production costs that the buyer does not have, The buyer then has to consider clever ways to infer the supplicr’s costs, such as offering the supplier several potential projects to choose from, each with an associated having the supplier select the one that will be produced. For an excellent summary of this literature see Laffont and Tirole (1993). In contrast, the approach taken here is more in line with that of Transaction Cost Economics as advocated by Williamson (1975, 1985), focuses on adaptation costs when contractual oe are incomplete. This is in line with the concerns of scholars practitioners of engineering and construction management. They argue that the central problem in procurement is not that suppliers know so much more than buyers at the onset of the project, but that instead, both buyers and sup- pliers share uncertainty about many important design changes that occur after the contract is signed and production begins. These changes are usually a consequence of design failures, unanticipated con changes in regulatory requirements.' The framework described builds heavily on Bajari and Tadelis (2001) (henceforth, BT) who formalize the procurement problem as one of smoothing oul or circumventing adaptations after the project begins rather than information revelation by the supplier before the project is selected. This chapter argues that the form of contracts and awardIncentives and transaction casts in public procurement 69 mechanisms can be tailored in a way to help mitigate this procurement problem. In particular, a trade-off between incentives to reduce cost and incentives to facilitate changes and share information will be the key force in the arguments for contractual choice. In particular, simple projects, which are defined as easy to design with little uncertainty about what needs to be produced, ought to be procured using fixed-price contracts, should be accompanied by high levels of design completeness (to prevent the need for adaptations), and are best awarded through competitive bidding. In contrast, complex projects, which are defined as hard to design with large scope for surprises in the con- figuration, ought to be procured using cost-plus contracts, should be accompanied by low levels of design completeness (implying a high chance that adaptations to the contract will be needed), and should be awarded through a negotiation with a reputable and qualified supplier. The intuition for these prescriptions stems from a tension between pro- viding incentives to lower costs and avoiding costly and wasteful renego- tiation that follows requests for changes. The strong incentives to reduce costs that are offered by fixed-price tendered contracts will lead the parties to dissipate valuable surplus when changes need to be renegotiated. This efficiency loss will often be due to haggling over prices when there is true lock-in of the current supplier who wishes to use the need for adaptation to his advantage. Cost-plus contracts, in contrast, discourage cost-saving efforts but ease the process of renegotiating changes and adaptation to the contract's original requirements.” The choice of payment procedures, such as fixed-price and cost-plus contracts, is tied in with the follow-up decision that a buyer faces: whether to award a procurement contract by competitive bidding or by negotiat- ing with a potential supplier. In the US the public sector statutes that govern procurement, typically based on FARs, strongly favor the use of competitive bidding. For example, Bajari er af. (2007) show that from 1995 to 2000, 97 percent of public sector building construction projects in Northern California were procured using competitive bidding. While competitive bidding does have the advantage of unbiased awarding of projects, it fails to respond optimally to ex post adaptation. This suggests that public procurement of complex projects are suffering from efficiency losses. The analysis in the next section begins with a simple framework to describe the buyer's choice of devising a contract that will govern the procurement relationship with a selected supplier. The analysis then con- tinues to describe how the contracts chosen will dictate the use of award mechanisms. A discussion of implications for public procurement is then offered.0 Regulation, deregulation, reregulation THE CONTRACTING FRAMEWORK Contractual Components: Design and Incentives The precursor to awarding a contract is devising one, so consider a buyer who wishes to procure a project (good or service) from a supplier. To get what he desires the buyer must provide the supplier with plans specifications that describe the project. If the project is built according to the buyer’s needs, he will obtain a value of ¥. Thus, the buyer's first dimension of contractual choice is how much design costs to invest at the onset, where more investment (and hence costs) in design creates a more detailed set of plans and specifications. Clearly. a more detailed and accu- rate design of a project reduces the need to renegotiate changes after the project starts taking shape. It is often prohibitively expensive to draft a complete design that fully describe the project exactly as the buyer's needs dictate, and how produc- tion should take place as certain contingencies arise. There is always a chanee that a contingency will arise for which their are no instructions, or for which the blueprints are insufficient. This implies that the specified design may not result in the successful completion of the project. This problem is referred to as contractual incompleteness because it is generally associated with the design and specifications not being a complete descrip- tion of what needs to be donc in the face of all future contingencies. The contractual incompleteness of the project will also depend on how prone the type of project is to unforeseen changes. Such unforeseen changes can arise from technological or regulatory contingencies that are hard to predict or plan for, or alternatively too expensive to try and draft onto the design. To capture this idea, define the complexity of the project as how expensive it is to provide a rather complete set of plans contin- z The more complex a project is, the more expensive it will be to try prevent contractual incompleteness. Formally, it is instructive to consider a complete design as a list of instructions that fully describe the project. Let t € [0, 1] represent the fraction of instructions that are actually written down by the buyer, interpret t as the probability that ex post adaptations are not needed, or as the design completeness of the project's design. With probability | — t, however, a contingency will arise for which their are no instructions, implying that following the prespecified plan will not result in the success- ful value v. In this case the buyer will only get a value of v < vy, which will later depend on the type of payment-ineentive scheme. To model project complexity, I suppress the state space model of BT focus on its reduced form. In particular, let T = 0 be a scalar thatIncentives and transaction costs in public procurement 71 represents the complexity of the project, where higher values of T imply a more complex project. (A natural interpretation of T is the number of instructions required to completely specify the project.) Providing a design completeness t [0, 1] for a project of complexity T costs the buyer dit, T). This can be thought of as the engineering Mill drafting costs that Bo into producing the set of design blueprints for the project, Assume that a(t, T) satisfies three properties (that are rather intuitive, and are endog- enously derived in BT). First, for a given level of complexity 7, the costs of design are increasing in design completeness t. Second, the cost of a fixed level of design completeness t is increasing in complexity 7. Finally, the more complex a project, the higher is the marginal cost of increasing the probability of specification, so that ad(t, T)/ataF > 0. The buyer's second dimension of contractual choice is the payment and incentive scheme in the contract. Most procurement contracts are variants of simple fixed-price or cost-plus contracts. In fixed price contracts, the buyer offers the supplier a pre-specified price for completing the project as specified, and any changes are negotiated separately at the stage in which they arise. A cost plus contract does not specify a price, but rather reim- burses the contractor for costs (time material) with an additional stip- ulated fee (the *plus’). Hence, in cost-plus contracts the costs of changes are automatically built into the original contract.’ Formally, Let » € {0, 1} represent the payment choice variable, where ¥ = Ois a cost plus incentive scheme, and 1 is a fixed price incentive scheme. It is customary to refer to fixed contracts as having high powered incentives lo reduce costs since he contractor is the residual claimant to every dollar saved on production costs (similarly, cost-plus contracts offer low-powered incentives). As Williamson (1985) suggested, the ease in which work adaptations are executed will depend on the con- tract employed. In particular, a cost-plus contract easily adapts to cover additional changes, while renegotiating a fixed contract generally involves more haggling and friction. I therefore assume that the value of the project when adaptation is needed, y(y), will depend on the incentive scheme so that v(0) > v(1). This means that if changes are needed then the buyer's ex past surplus is lower with a fixed price contract than it is with a cost plus contract. (This inequality is derived more thoroughly in BT.) ‘The Costs and Benefits of Incentive Schemes To compare the advantages of each incentive scheme, first start by ignor- ing any changes to the original design, assume that the project will be executed exactly as the design specifies. Ifa fixed-price contract is in place then the supplier bears all of the costs of providing the project. This, of2 Regulation, deregulation, reregulation course, implies that the supplier has strong incentives to lower the cost of production, and some of these would pass on to the buyer through competitive pressures (that are discussed further in the next section). In contrast, if a cost-plus contract is in place then the supplier knows that any extra costs he incurs will be fully compensated for, may even generate a small profit if the fee is based on a percentage of the costs. Thus, the supplier will have no incentives to reduce the costs of production, and no such costs savings can therefore be transferred to the buyer. Formally, the above argument suggests that one can describe the buyer's cost of a project, cy), a8 depending on the incentive contract that is used. Stronger (fixed. ) incentives imply a lower direct cost of production because contractors are the residual claimants of costs and they will make choices to reduce the costs of production, so that c(0) > e(1).* That said, cost-plus contracts have an appealing feature that has been recognized by scholars and practitioners in the area of construction man- agement, in that they facilitate changes and modifications to the original specifications. Indeed, the most common sources of changes in building construction are defective plans and specifications, changes in project scope differing conditions than expected at the site of construction. Conventional wisdom in the industry is that cost plus contracts are better suited to facilitate such change. To see why, imagine a situation where at some advanced stage of the project's development it turned out that the plans and specifications are defective, or lacking some directive for an unforeseen issue that arises. In such an event the buyer will ask the contractor to adopt some changes to the original plan. First consider the effects of having a fixed price contract in place. The fixed compensation binds the supplier to the original plans and does not oblige him to agree lo the changes proposed by the buyer. Thus, the buyer have to negotiate any changes with the sup- plier. The buyer's objective is to get the changes done in the most cost effective way according to his needs while the supplier wishes to make as high a profit as he can from the potential windfall. The supplier can then hold up the buyer as a consequence of being in the midst of the project, he has no competitive pressure to discipline his behavior. Knowing this, the buyer may expect to be overcharged the two parties are likely to engage in contentious adversarial negotiations, Alternatively, consider the effects of having a cost-plus contract in place. Unlike the specific-performance nature of a fixed price contract, a cost-plus contract effectively has a built-in mechanism to compensate the supplier for any changes that are required. Namely, any additional costs that the supplier incurs are compensated for through the cost-plus structure.* In other words, the lack of cost-reducing incentives serves as