It has been shown in 5.3.1 that there are circumstances in which the government tries to simulate competition in purchasing supplies of equipment. The government advertises for firms to tender for contracts which specify the type, quality and delivery dates of equipment and the award will be made to the firm which offers the lowest price.
Imagine that you are invited by a government department to review its purchasing policies for equipment. You discover that the prevailing policy is only to allow firms selected by the Department to make a bid. In other words, freedom of entry into the tendering process is restricted. You question this procedure and this is the answer you receive in the form of a memorandum from the officer in charge of purchasing policy.
It is agreed that the aim of purchasing policy is to minimize the cost of contracts and that, in theory, open competition would achieve this aim more fully than limited entry into the tendering contest. However, the model to which you refer ignores some important characteristics of the government-contractor interface. These are now listed.
The transactions costs involved in distributing details of contract, examining tenders and then informing bidders whether they are successful or not are high. Limiting the number of bidders reduces this cost.
The search costs rise with the number of bidders who must be checked as to their reliability and financial ‘soundness’. Increasing the number of firms approached in the name of seeking lower prices, has to be balanced against the costs of obtaining this extra information. We find it much more satisfactory, on the basis of extensive experience, to work from an approved list of firms of known reliability.
Bargaining costs are increased as the number of bidders increases. This happens because with open competition there is a greater probability that the firm offering the lowest price will default, through bankruptcy. If bankruptcy occurs, the Department gets involved in tedious negotiations over reneging on the contract conditions and over the terms and conditions of a replacement contract with another firm or firms.
Tendering costs are high for individual firms and this means that the longer the tender list, the higher the total costs incurred in ‘abortive tendering’ by unsuccessful firms. With fewer firms, fewer resources will be wasted on preparing tenders and false expectations of success are minimized.
In short, the argument for open competition ignores the considerable costs incurred by both the Department and suppliers in trying to simulate competition. This is why we normally restrict the number of bidders to between five and eight.
You are asked to offer a critical evaluation of the above Memorandum no longer than the Memorandum itself (senior officials are busy people!).
Figure 5.1 can be used in order to illustrate some of the features of the bargaining process between government and a single firm from whom it wishes to purchase a particular piece of defense equipment. In order to test your understanding of this figure, consider the following cases:
The purchasing authority is assumed to have full information about the combinations of labour and capital which would minimize the cost of producing the agreed piece of equipment. It also wishes to impose a rate of return constraint as depicted in line OP. The firm is assumed to be a profit maximizer but it will not agree to supply the equipment unless it receives a minimum total profit. Using Figure 5.1 indicate the condition necessary to induce the firm to supply the equipment.
The purchasing authority does not have full information about the minimum cost position, but imposes an upper limit on the amount it is prepared to pay for the piece of equipment. As in Question 5.2, the purchasing authority imposes a rate of return constraint. The firm is not a profit maximizer, a situation which could arise if the management were powerful enough vis-à-vis shareholders to substitute the prospect of higher emoluments for profits in negotiating with government. At the same time, it has to pay shareholders enough to induce them to continue to invest in the firm, i.e. it must make a minimum total profit. Using Figure 5.1, investigate the circumstances in which the firm might operate ‘wastefully’, using resources that add nothing to output.
The purchasing authority is faced with an interesting problem in fixing a profit constraint. On the one hand, it will be under pressure from the Ministry of Finance and perhaps the legislature not to pay inflated profits. On the other hand, it must offer a profit rate which is sufficient to induce a firm to accept contracts. If you were a financial adviser to a firm negotiating with government, would you consider it reasonable to accept a profit constraint which earned the firm a rate of return on capital employed which was equivalent to the average rate of return for manufacturing industry in the country in question?
Examining the numerical example in Table 5.1, further investigation would demonstrate that the variation of profits with respect to costs follows a consistent pattern. This must follow from the fact that if total costs prove to be below the estimated amount in the contract, then the excess profits are subject to a fixed rate of tax. Similarly if costs exceed estimate, then only a fixed percentage of the excess costs are allowable. In the former case, a percentage tax β (where β < 1) will reduce profits by P times the excess profits. In the latter case, a percentage tax β (where β < 1) will reduce allowable costs by β times the excess costs. In each case – excess profits or excess costs – it should be possible to devise a simple formula which would demonstrate how the total allowable profit can be ascertained.
You are asked to derive
A profit formula for the calculation of total profit when excess profits are subject to a percentage tax.
A profit formula for the calculation of total profit when excess costs are subject to a percentage tax.
(Clues: when there are neither excess profits nor excess costs, clearly total profit will equal estimated profit. Call the percentage of cost allowable as profits, α, where α < 1.)
