In many economic situations where buyers and sellers confront one another, it is reasonable to assume that all parties are profit or utility maximizers, that buyers have alternative opportunities for purchasing and that sellers compete through price and quality. In the analysis of the market for any particular product, it must be realized that the market environment changes through time, which means that the static models of the kind with which we introduced ‘government and industry’ (see Section 1.3) have familiar limitations as expository devices. However, the market environment governing the relations between government and its suppliers may be far removed from that which is applicable to transactions between many buyers and sellers wholly within the private sector.
It may help to use an extreme, though not unrealistic, example – that of a defense contract to purchase a new nuclear missile which is to replace an earlier missile. There are technical and institutional reasons why the government may be faced with a very restricted number of suppliers. Taking the technical reasons first, the building of a nuclear missile may require a large initial capital investment. At the same time, if the firm producing the missile bears all the risks of production, it may find itself subject to both uncertainties about the technical feasibility of being able to produce the missile and about its rate of obsolescence. Looking at the institutional factors, the government is likely to wish to specify that the missile meets very particular requirements and also that the sale of the missile to other governments or firms is to be forbidden or that it is to be sold only under strict license, for the missile's effectiveness may depend on its being technically superior to those in the charge of hostile governments. To competing firms such a condition will further reduce the attractiveness of producing the missile because the government will be in the position of a monopsonist, and therefore potentially able to influence markedly the terms on which the missile is sold to it. Both the technical factors and the institutional factors will encourage the growth of countervailing power to government monopsony. This is likely to take the form of merger of firms in order to take advantage of technical economies of scale and to attempt to restrict alternative sources of supply other than from the merger.
In the late 1990s an Invincible aircraft carrier cost about £350m. and a nuclear-powered submarine about £250m (1989 prices). Their design was undertaken jointly by the British Ministry of Defense and private industry. The initial designs were prepared principally in the Ministry but shipbuilders had to be brought in at an early stage if they were to form some idea of cost estimates. As the cost of a major warship ruled out the use of prototypes in the design and development phase, this work had to be carried out in considerable detail before an order could be placed. In recent years, all important Royal Navy warships and submarines have been built by British Shipbuilders, a consortium of companies, and only three of its members specialize in warship-building. Orders for ‘first-of-class’ warships are normally placed with the shipbuilder who undertakes the design work.
It would be an exaggeration to claim that market conditions for the whole range of government procurement are characterized by bilateral monopoly conditions. Governments purchase a whole variety of everyday goods – furniture, stationery, vehicles – in which they have no monopoly power and in which more or less competitive conditions prevail. Furthermore, government departments which judge that competition is not an option may specify that their suppliers must use competitive tendering at the sub-contracting level. However, the range of activities within which conditions more akin to those described in Section 5.2.1 prevail is wide enough to direct some discussion towards situations where competition is restricted in the procurement market. We shall also observe that the motivation of those in charge of procurement may favour such restriction (see Section 5.3.1).
The British Ministry of Defense occasionally gives a breakdown of the proportion of contracts (by value) subject to competitive tender. In the 1990s, 28 per cent of contracts were placed by competition, 21 per cent of contracts were ‘placed otherwise by reference to market forces’ (e.g. selective tenders negotiation of discounts, etc.), and 51 per cent of contracts are noncompetitive. Ten years before, 70 per cent of all contracts were non-competitive.
Source: HM Treasury (1990), Chapter I
The procurement policy must depend on the objectives of purchase by the government. A phrase such as ‘the government wishes to obtain value for money’ is empty without defining closely what ‘value’ means. There are two problems in giving meaning to such a phrase and they are clearly illustrated by the example of defense expenditure. The first is that defense output is very difficult to define and the second is that once some suitable definition is found, there is a conflict of interests concerning the amount of output which should be produced and therefore the inputs which should be purchased from industry.
The purpose of a defense programme is presumably to remove the threat of external attack, but governments have to rely upon the assessment of the ‘mix’ of weapons which will minimize that threat by technical experts who design and develop weapons and upon those who use them, i.e. upon scientists and military experts. Being monopoly suppliers of information on such matters probably offers an incentive for them to exaggerate the ‘need’ for defense inputs. Scientists will emphasize also the ‘spin-off’ (in the form of technological advance through such programmes) which benefits other services, while ‘according to military men we are never safe’.
In preparation of the Defence expenditure estimates for the planning period 2000–03, the UK Treasury came into direct conflict with the Chief of the Defence staff who appealed directly to the Prime Minister. The Chief claimed that the government's own objectives could not be achieved unless his budget was considerably increased. He managed to obtain an increase of £24b.
Even if one could rely upon scientists and military experts to produce programmes which minimize the physical inputs necessary to meet the defense objective, there remain the important questions of the choice of suppliers of weapons and of the contractual arrangements concerning their supply. Here again it must not be assumed that there are strong enough incentives to minimize the cost of inputs for a given output of defense. Whereas voters in general, as taxpayers, may have an interest in the minimization of cost, it is the effects on themselves as producers which are likely to be much more obvious. The effect on jobs is much easier to grasp than the effect on the taxpayer's individual tax bill. Consequently, vote-sensitive governments have to think twice about placing contracts with overseas suppliers who might be able to outbid domestic suppliers and about switching contracts away from ‘traditional’ suppliers (representing specific producer and union interest groups) towards ‘new entrants’. In the latter case, the problem for government may be complicated by the objectives of regional and industrial policies, particularly the pressure to maintain and improve employment prospects in specific areas and /or industries.
In establishing a single market within the EC, introducing more competition in public purchasing has been a contentious issue between individual states and the Community authorities. While member states have been committed to international competition, it has proved difficult to get agreement on the application of competitive procedures to the purchase of military equipment, energy, transport and telecommunications equipment. Although it seems likely that more competition will prevail, certain sectors, notably armaments, seem certain to be excluded and purchasing from ‘less-favoured regions’ in a particular country will continue for a long time.
It is highly unlikely that any briefing to procurement officers in a government defense programme, based on the considerations of the last paragraph, would remove all opportunities for them to exercise discretion. As Section 5.2.2 indicates, the incentive for those in charge of procurement to minimize input costs is weak. The producers of defense goods may face margins of error in making cost estimates covering a period of time well into the future, ranging from the development stage, through the testing of prototypes, to the eventual production of weapons. They will bargain for financial provision which makes generous allowance for uncertainty via contracts which allow for price adjustments if cost estimates turn out to be higher than could reasonably be expected and which are elastic in respect of delivery dates. Procurement agencies, as utility maximizers, may go a long way to accommodate the demands of suppliers, subject to some obvious constraints, such as avoiding condonation of ‘excessive’ profits earned by producers and rooting out corrupt practices of public officials who may be tempted to accept bribes in exchange for the award of contracts.
On the one hand, heads of procurement agencies, in common with those of other government agencies, may derive utility from the total size of their budgets (see Section 7.2) upon which their status and prestige may depend. On the other, the time, skill, effort and aggravation generated in disputes about cost estimates may mean that the marginal utility of cost minimization to procurement officers will diminish rapidly. The problem is made all the more difficult by the fact that cooperation of suppliers in advance of drawing up contracts is essential; and suppliers are frequently the main and sometimes the sole source of information about cost conditions, at least within the time span during which negotiations are relevant. (It is conceivable that alternative sources of information about costs could be found but the costs of search may be prohibitive.)
It is estimated that in the UK the Ministry of Defense lets 50 000 contracts per annum and that over 100 000 contracts are in operation at any one time.
In conclusion, there may be no way in which an effective contract can be drawn up requiring suppliers to minimize costs and in a way which allows adherence to the terms of the contract to be monitored – quite apart from the lack of incentives to procurement agencies to insist on such contractual arrangements in the first place.
