5.3 Some Economics of Government Purchasing Policies

Despite the complications presented by the complex motivations of governments and their employees which may blunt incentives to minimize costs, it is not unreasonable to assume that the government wants to acquire the reputation with voters of being an ‘efficient’ purchaser, in the sense of obtaining the best price it can per unit of goods supplied, with strict adherence to delivery dates and quality guarantees. Likewise, although we have stressed that firms are complex organizations whose utility functions contain several ‘arguments’ other than the maximizing of profits accruing to shareholders, it is not unreasonable to assume that, as a first approximation at least, firms will base their pricing, delivery and quality control policies on the need to maximize profits. The final ingredient in the preliminaries to further analysis is represented by the uncertainties surrounding the production processes governing the kind of products governments wish to buy, particularly in the defense area. These vitally affect cost estimates along with the other kinds of uncertainties which normally affect firms. There is a strong incentive for each party to the contract to try to offload the non- insurable risks onto the other. Three cases may now be identified which attempt to explain the nature and consequences of actual government contracting procedures.

5.3.1 The Government as Monopsonist

In the first case we assume that the government is a monopsonist faced by competing suppliers of a product, e.g. motor vehicles, where the product can be clearly specified, the technical process of production is certain, and firms have accumulated experience in cost estimation. In such a case the government will favour competitive tendering by firms for a fixed price contract. This is because the cost of specifying the contract will be relatively low, and competition between firms will ensure that the price per unit supplied will be minimized, for minimizing of costs by firms will be the means by which they will maximize profits. In turn, the costs to the purchasing agencies of the search for the offer which best fits the specification of the purchase will be relatively low, for firms will have an incentive to compete against each other in revealing information on their activities. Suppliers, therefore, will bear most of the risk.

The reader will notice that this extreme case has all the characteristics of the static equilibrium analysis the shortcomings of which were examined in Module 1, particularly the assumption that firms have no incentives to alter their position as passive adjusters to government policy instruments. Economic analysis alone would suggest that firms faced with a monopsonist might consider the following tactics:

1. They might seek alternative markets in order to reduce dependence on government, i.e. alter the market form by changing the monopsony characteristics on the demand side.

2. They might merge, i.e. alter the market form by changing the competitive characteristics on the supply side.

3. They might collude over the tenders submitted, the extreme case being where tenders are identical in respect of price, quality and delivery dates, i.e. alter the market form as in (b).

4. Individual firms, knowing that public employees' pay is not a function of their success in negotiating contracts, might offer purchasing agents a ‘share’ (more commonly called a bribe) in the profits which will accrue if the contract is awarded. The market form is altered by reducing the homogeneity of the product. This need not take the form of a direct covert money payment at the time of contracting but the offer of employment to government employees on resignation or retirement.

5. They might put pressure on government to create an ‘orderly’ market in contracting by lobbying for restriction on entry to tendering, e.g. exclusion of tenders from overseas suppliers (but see Example 5.5).

The extent to which these methods will be employed will clearly depend on how firms perceive the costs and benefits of individual or collective action. Both costs and benefits may be influenced by the view taken by government of competition policy as well as by the role played by corruption in the execution of policy.

5.3.2 The Government in a Position of Bi-lateral Monopoly

The second case that we consider is where the government purchasing authority decides to contract with one firm only, that is to say, the position is one of bilateral monopoly, at least in the short run. This is also the ‘market form’ in the third case considered below, but in this second case we continue as in Section 5.3.1 so that a fixed price contract is appropriate, it being assumed by the purchasing authority that the contract can be clearly specified on the basis of information supplied by the firm which is not faced with major uncertainties about the costs of production.

Typically a fixed price contract will require the following:

1. Agreement on the estimated outlays for the required level of output. These outlays will be based on two groups of calculations, the first being the relation between the scale of output and direct costs (i.e. costs such as labour input costs) which vary with output and the second being the estimated fixed outlays ( administrative overheads, plant and machinery) which do not vary with output. Generally fixed outlays are based on some percentage of direct costs.

2. Agreement on the profit margin. Typically, governments will negotiate a profit margin based on the rate of return on capital employed or sometimes as a percentage of estimated outlays.

3. Agreement on the quantity and quality of output.

4. Agreement on delivery dates.

In contrast with the first case the spur of competition, which would induce competing firms to reveal information on their costs, is missing. The government cannot lay off the estimates of one firm against those of another and has to rely on the firm itself to supply the information required or face the alternative of incurring considerable costs in seeking to discover whether the firm's estimated costs are reasonable. If firms are successful in inducing the government to accept ‘inflated’ cost estimates, they can then earn ‘excess’ profits. In order to avoid the charge of being inefficient purchasers, purchasing agents may seek to operate some form of further control on profits, such as sharing profits with the firm over and above some agreed minimum total profit per contract or by restricting profits earned to some percentage of costs or of capital employed.

We have taken the example of a fixed price contract with a profit constraint in the form of a maximum percentage of capital employed, so that we can explore the parallel between a firm subject to a regulatory constraint (see Section 3.4) on profit but able to sell to any buyer and a firm whose sales are restricted to a fixed amount bought by government alone. Figure 5.1 is a development of Figure 3.3. If the firm selling all its output at a given price to government were forced to reveal its ‘true’ costs, it would be in a similar position to the firm depicted by line 0P passing through point A. The best that the firm could do is to produce the given output with 0L₁ of labour and 0K₁ of capital. However, if it is able to ‘inflate’ the costs estimate and have it agreed by the purchasing agency, then in terms of our diagram the estimated iso-cost line shifts to the left and the profit curve shifts to the right. As drawn, this produces a situation where the firm can improve its profits by using more capital (0K₂) and less labour (0L₂), that is to say it moves away from the minimum cost point. Only if the profit constraint were to provide a rate of return on capital higher than that earned by the firm at point B (i.e. rate of return on capital π₂/K₁) so that the profit constraint line passed through B or to the right of B, would the firm be induced to minimize its costs using 0L₁ of labour and 0K₁ of capital.

Figure 5.1 Bargaining between government and firm

A common policy dilemma of government is highlighted by this example. On the one hand, in the absence of a profit constraint, if the government makes an error in the estimated costs, because of the lack of incentive and opportunity to institute elaborate cost checks, then the supplying firm is induced to minimize costs, i.e. to behave efficiently. The government, however, is faced with a redistribution problem because of the relatively large profits that are condoned by the process of bargaining. On the other hand, if the government institutes a profit constraint in the form of a maximum rate of return (a) on capital (K), then it is likely to encourage firms to waste capital in their attempts to maximize profits.

5.3.3 The Problem of Uncertainty

The third example introduces the problem of uncertainty. As explained in Section 5.2.2, government purchasers frequently find that they have to be closely involved in the development of the product they wish to buy. There is pronounced uncertainty, therefore, about the costs of production and the time scale covering the period from development to final production. Placed in this position, both the firm and the government purchasing agency will seek to bargain over the sharing of risks. On the one hand, an individual firm will not wish to accept a fixed price contract if the final outcome may be so uncertain that it could be faced with large losses. On the other hand, the government will not be willing to offer the firm a blank cheque so that in effect it covers all the risks given the possibility that the firm may be lax in cost control and in the meeting of deadlines.

Economic logic would suggest that the last control device that the government would wish to use in this situation is a cost-plus contract, that is, one in which the firm can recover all its outlays on development costs of a product, regardless of what these might be, plus a profit percentage. Such contracts have been widely used in defense contracting in various countries, and would clearly indicate that purchasing authorities were not properly monitored or that the ‘monitor’, i.e. eventually the government, was interested in aims other than minimization of costs. When governments are under pressure to exercise stricter control over expenditure than hitherto, they tend to generate devices which place more of a risk burden on suppliers. For example, the government may agree a target cost with a firm undertaking development work and a profit rate based on such costs. If the actual cost then equals the target cost, the firm receives its costs plus the agreed profit rate. If the actual cost is less than the target, the government ‘taxes’ the excess profit by taking back a percentage of the excess. If the actual cost is greater than the target, only an agreed percentage of the excess cost is paid over by the government. In addition a maximum and/or minimum profit total may be built into the contract.

A simple tabulated example (as shown in Table 5.1) explains how the purchasing authority might approach the problem of risk-sharing. Item 1 represents the forecasted cost for a particular contract for a given number of items of equipment (Column 1). The profit rate is 10 per cent of estimated total cost (Column 4). Therefore, total profit (Column 2) is 10 and the total outlay by the purchasing authority is 110. If actual costs turn out to be lower than 100 (see Item 2) and the contractor received the same total outlay, the total profit would obviously be 20 and the profit rate 22.2 per cent. The best protection of the purchasing authority against the risk of overestimating costs is to ‘ tax’ the profit. Item 3 illustrates the case in which a tax of 50 per cent is imposed on the excess profit. The profit rate is reduced, but both the total profit and the profit rate are above their targets. Item 4 illustrates the opposite case where actual costs are higher than estimated by ten. At a 10 per cent profit rate, profit would be greater than the target. Some protection against risk is obtained by a ‘tax’ on the excess cost. With a tax of 50 per cent, and a profit rate of 10 per cent, total outlays remain higher than estimated, but total profit is only slightly increased. In this last case (Item 5), the purchasing authority might hold out for a lower rate of profit so that the total profit received does not exceed that contained in the forecast (Column 2 for Item 1).

This analysis illustrates what would be the result of the contract, but not the outcome of the negotiations over the contract itself. Both parties have to bargain over the value of the two variables – the target cost and the profit rate. The firm will have a clear incentive to maximize target cost (plus the percentage profit) under conditions of uncertainty for by doing so it minimizes the probability that costs will be higher than estimated and therefore the probability that profits will be lower than estimated. It also improves the probability of obtaining excess profits by producing at costs less than estimate. If the government faces the kind of estimating and monitoring difficulties already described, then it has to fall back on other elements in the contract which are of importance to it. These may include penalties for late delivery (although delivery dates may also be difficult to establish with development work), and the sharing of property rights, particularly patents taken out for development work, which would enable government, in the longer run, to award contracts beyond the development stage to other suppliers.