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Third-Party Opportunism and the (In)Efficiency of Public Contracts

By Marian W. Moszoro and Pablo T. Spiller

The lack of flexibility in public procurement design and implementation reflects public agents’ political risk adaptation to limit hazards from opportunistic third parties—political opponents, competitors, interest groups—while externalizing the associated adaptation costs to the public at large. Reduced flexibility limits the likelihood of opportunistic challenge lowering third parties’ expected gains and increasing litigation costs. We pro-vide a comprehensible theoretical framework with empirically testable predictions.

JEL Classication: D23, D72, D73, D78, H57

Summary

The way a competition is structured can be a determining factor in whether competitive pressure is sufficient to balance the additional development costs of multiple contractors and the higher unit costs from splitting the award in defense acquisitions. In some instances, the structure of the competition can actually incentivize contractors to bid higher and drive up costs.

In contrast to private contracts, public contracts are open to challenge by third parties. The whiff of corruption and the concern for misuse of other people’s monies1 make challenging public contracts feasible. Even though the enactment and performance of a contract may be honest and legal, public agents may fear politically motivated challenges, and hence will ex ante adjust the nature of the contracts so as to limit those features whose probity may be questioned. These adjustments will imply more contract specificity in design and rigidity in implementation. Such contractual adaptation, however, is not costless. Contractors’ perception of specificity and rigidity will translate into ex ante higher prices as well as the enactment of stronger compensating clauses. The contractual complexity and adaptation required to limit the potential for third-party challenges, whether opportunistic or not, make public contracting look “inefficient.”

The higher level of contract specificity and rigidity in public contracting can be under-stood, then, as a political risk adaptation by public agents.2 It is not that civic-oriented legislation limits public agents’ discretionary actions with “red tape,” but rather that public agents limit their exposure to the risk of third parties’ challenges through contract formalities and rigidities, externalizing the associated costs to the public at large.

This paper provides an operationalization of Spiller’s (2008) third-party opportunism (TPO), towards an understanding of the organizational foundations of pricing, specificity, and rigidity—the outer features (Spiller and Tommasi, 2007)—of public contracts. Spiller’s framework of public organization is rooted in a transaction cost-cum -positive political theory and follows Williamson’s four cornerstones of the economics of governance—namely, gover-nance,3 transaction costs,4 adaptation,5 and interdisciplinary social science6—and introduces third-party opportunism as the quintessential hazard of public transactions.

1. Prior Literature

Third-party opportunism relates to a threefold literature on public contracting:  industrial organization, public administration, and political economy.

In the industrial organization literature, public contract pricing is fundamentally deter-mined by informational costs, arising from informational asymmetries, the extent of verifiability of information, and the presence of repeated interactions (Bajari and Tadelis 2001; Laffont and Tirole, 1993; Loeb and Surysekar, 1994; Macaulay, 1963). According to Marshall, Meurer, and Richard (1994a), when terms can be contested by excluded sellers, agreements are carefully delimited and more formal features govern them. It is, however, the nature of the hazards from opportunistic third parties that determines the fundamental features of public procurement and contracting.

Whereas the parties in private-private relations adapt to new information as it becomes available in order to save litigation costs, and courts are used rather to terminate disputes, public contracts appear bureaucratic and over-monitoring in situations in which it is not needed (Prendergast, 2003, 932–933). According to the public administration view, contracting inefficiencies are associated with the large number of formal processes that appear to be essential to ensure the  public sector’s functions as well as with “red tape,” i.e., costly and compulsory rules, regulations and procedures with no efficacy for their functional object (Bozeman, 1993, 274). Bureaucrats are used only for “hard” agency problems, where consumers cannot be trusted (Prendergast, 2003, 933). Extensive rules and regulations arise from dividing authority among the separate branches of government (executive, legislative, and judicial), designed to prevent abuses of power, protect people’s rights (Baldwin, 1990, 10–11), and reflect equity values not necessarily present in private firms, including educational, health-related, legal, and environmental (Forrer, Kee, Newcomer, and Boyer 2010, 480). Red tape regulations are intended to decrease public employees’ uncertainty about how they should behave (Kurland and Egan, 1999, 440). Both formalities and red tape are the instruments by which bureaucracies restrict public agents’ discretion (Boyne, 2002; Lan and Rainey, 1992) and “overcome the temptation to capitulate to consumers simply to avoid complaints” (Prendergast, 2003, 932).

The political economy profession has long been divided into advocates of public interest theory (in line with the public sector motivation literature), and “capture” or interest group theory of government intervention in industries, seeded by Buchanan (1965) and Olson (1965), and elaborated by Stigler (1971). This positive approach, both in its Chicago school (Becker, 1983; Peltzman 1976; Stigler, 1971) and Virginia school (Buchanan 1975; Buchanan, Tollison, and Tullock, 1980) modalities, concentrates on the demand-side, “black-boxing” the supply-side of political decision-making (Laffont and Tirole 1993, 475–476). On the other hand, positive political theory scholars, led by Riker (1963), focused on the supply-side of political decision-making, studying how politics—legislative procedures, administrative  procedures, and bureaucratic oversight—affects legislative, judicial, and regulatory behavior.

Positive political scholars have also studied the use of interested parties (McCubbins and Schwartz, 1984; de Figueiredo, Spiller, and Urbiztondo, 1999) and consumers (Prendergast, 2003) as instruments of oversight.

Laffont and Tirole (1993) emphasize that the link “between procurement and regulation and the associated administrative and political constraints is still unknown to us or is still in a state of conjecture. […] Institutions are endogenous and should as much as possible be explained by primitive considerations.” This paper is an attempt to rationalize the basic features of public contracting from its primitive considerations:  its fundamental hazards.

2. A Model of Third-Party Opportunism

2.1. Signaling Process: Hazards into Rigidity

We focus our analysis on the public agent’s perspective. Furthermore, we ignore sunk costs to abstract from governmental opportunism  and to make the argument on TPO straightforward.

There are four agents explicitly and implicitly involved in public contracting:

  1. Incumbent public agent
  2. Private contractor
  3. Third-party challengers, i.e., political opponents to the incumbent public agent, competitors to the contractor, and interest groups
  4. Public at large, i.e., voters and courts

The signaling process starts before the contract is signed. The public agent receives project features and budget P bud to contract for goods and services. The public agent perceives the threat of potential third-party challenges and tries to minimize political risks and maintain political support. The private contractor may not be directly aware of the hazards faced by the public agent, but observes contract specificity and rigidity. Specificity and rigidity equal less adaptability, higher contracting and implementation costs, and hence higher final prices charged to the public agent. Third parties privately perceive the benefits from challenge. Contract features affect third parties’ strategies, thereby affecting political out-comes. If a public contract does not meet the public’s expectations, political consequences may include weakened chances of re-election or re-appointment for incumbent public agents, judicial challenge, and loss of reputation and current position. Figure 1 presents the timing of the signaling process from third-party hazards into contract rigidity.

Figure 1. Signaling Process: Hazards Into Rigidity—Timing

loc-8-figure-1

2.2. Conceptualizing Contract Specificity and Rigidity

Contract specificity refers to ex ante complexity of subject, completeness of clauses, technical provisions, and processing costs (Laffont and Tirole, 1993, 307). Contract rigidity refers to ex post enforcement, penalties, hardness, and intolerance to adaptation of contracts,9 and normally correlates with contract specificity:   the more specific the contract is, the more rigid its implementation and enforcement is expected to be. Otherwise, if the contract is specific and then the parties agree to deviate, third parties can accuse the contracting parties of collusion. We treat specificity and rigidity hereinafter as interchangeable.

Complex public contracts have more contractual rigidities than simpler contracts. The cost of ex post enforcement increases in complexity. Because the public sector has more ambiguous objectives than private organizations (Boyne, 2002), and it is difficult to assess to what extent these objectives are achieved (Lan and Rainey, 1992), public contracts’ high rigidity mitigates ambiguity and problematic evaluation. For example, U.S. Department of Defense directives specify in great detail source selection policies, including the development of objective technical, cost, schedule, manufacturing, performance, and risk criteria, the auction techniques, the organization of the selection committee, and the pertinence of contacts with contractors.10 Public agents must also follow imposed standards of evidence, and may be constrained to formulate standards and follow their own rules to avoid discriminating between distinct situations on the basis of non-verifiable information (Laffont and Tirole, 1993, 5).

2.3. Modeling Hazards, Rigidity, and Pricing

To illustrate and operationalize the third-party opportunism theory of public contracts, we introduce some simple notation.11 Third-party challenges may arise from honest attempts to control costs and from opportunistic attempts to replace the public agent. Public agents’ third-party related costs, then, have two components:  expected third-party opportunism costs E(T) concomitant with political costs of loss of office, reputation, and support that arise from contract discretionary terms (flexible contracting), and third-party adaptation costs K that increase expenses associated with the contract. If a third-party challenge is successful, there are also costs associated with the financial and social costs of a new tender, i.e., time and documentation,12 or settlement awards made by the winning bidders to protesters in exchange for a promise to drop their protest (Marshall, Meurer, and Richard, 1994b). We underline political13 costs as the main burden for public agents concerning third-party challenges, which are difficult to appraise, let alone to measure financially. The more discretionary the contract terms are, the more room there is for third parties to challenge the contract. Therefore, we assume that expected third-party (both honest and) opportunism costs E(T )—both honest and opportunistic—can be mitigated by contract rigidity R ϵ (0, ∞).14
Hazards faced by the public agent  are subject to the likelihood of TPO  challenge τ and the likelihood of success of TPO challenge τ ,15 which are driven by contract complexity (sector-specific) and political contestability.

The likelihood of success of a challenge τ is common knowledge to all players. Given that it is harder to prove wrongdoing when there is less room for discretionary actions, the likelihood of success of a TPO challenge τ is assumed to decrease in rigidity R, as the courts are more likely to dismiss and the public to ignore challenges to more rigid—“narrower”— contracts. Likewise, in order to fit to more rigid contracts, an opportunistic challenger will have to incur higher monetary, political, and reputational costs of challenge and litigation c. Therefore, the cost of challenge and litigation c is assumed to be increasing in rigidity R.  τ and c capture the critical institutional  features germane to TPO. We formalize these institutional features in Assumptions 1 and 2:

  • Assumption 1 The likelihood of success of an opportunistic challenge τ is convex and monotonically decreasing in R, so that loc-8-equation-1
  • Assumption 2 The cost of challenge and litigation c is concave and monotonically increasing in rigidity R, so thatloc-8-equation-2

Expected third-party opportunism costs E(T) depend on the political costs of a successful challenge to the incumbent public agent, and also on the costs of a new tender (documen-tation, new analyses), cost of externalities (including the value of lost time for users),16 and the public agent’s reputation.

Definition  1 E(T) = E[T(R)] = T0 ρ(R)τ (R where T0  is the public agent’s cost if a TPO challenge is successful. Larger projects are associated with potentially larger TPO costs to the public agent and benefits to third parties, therefore are linked to higher T0. Third parties observe benefits from opportunistic challenge T0, but the public agent does not know ex ante the particular value of T0. The public agent’s beliefs about benefits of opportunism for third  parties normally, with mean µ and standard deviation σ2.

The public agent endogenizes the likelihood of challenge ρ by adjusting rigidity R. The top likelihood of a TPO challenge ρ is given by the probability of a positive expected benefit for third parties, i.e., it is the complementary of the cumulative probability of third parties’ expected benefits from an opportunistic  challenge being equal or lower than the cost of challenge c: ρ = Pr(Ŧ > c) = 1 − Pr(Ŧ − c ≤ 0).

An increase in rigidity R carries two effects:

  1. It lowers the likelihood of success of a TPO challenge τ; hence, for any given continuous distribution function of third parties’ expected political benefits from contract challenge, it yields a scalar transformation distribution function which is first-order stochastically dominated by the distribution function at lower rigidity R (downward probabilistic shift of the cumulative distribution curve of expected third-party opportunism benefits Ŧ)
  2. It increases cost of challenge c and thus it decreases the probability at which an oppor-tunistic challenge pays off (rightward move of the cost of litigation)

Figure 2 shows a graphical representation of the combination of these two effects resulting in a decrease in the likelihood of challenge ρ due to an increase in contract rigidity R. ρ is, therefore, given by the probability of a positive expected value of a challenge Pr(Ŧ − c > 0). The public agent adjusts R ex ante according to her beliefs about the likelihood of incidence ρ and likelihood of success τ of third-party challenges. The public agent’s rational expectationof ρ is consistent with third parties’ costs and strategic decision, i.e., E(q | R) ≡ Pr[T0ζ τ (R) > c(R)] ≡ ρ.

loc-8-figure-2Figure 2. This graph plots the cumulative probability (y axis) of the public agent’s beliefs about third parties’ expected benefits from an opportunistic challenge (x axis): blue solid line for low rigidity and red dot line for high rigidity contracts. It assumes low rigidity RL = 10, high rigidity RH = 30, a normal distribution of benefits from an opportunistic challenge for third parties T0 ranging from 0 to 100 with µ = 30 and σ = 20, τ = ln[exp(1) + R]−1 , and cost of litigation  c = γR + 10, where γ = .2 and 10 are calibration parameters for an increase of c in R.  The likelihood of a TPO challenge ρ is the complementary cumulative probability of the third parties’ expected benefits from an opportunistic challenge being lower than the cost of challenge, i.e, ρ = 1 − Pr(Ŧ< c) = Pr(Ŧ − c ≥ 0). The cumulative distribution function at high rigidity is first-order stochastically dominated by the cumulative distribution function at low rigidity.  An increase in rigidity from R from 10 to 30 induces a decrease in the likelihood of TPO challenge from .5 to .1.

Proposition 1 The likelihood of challenge ρ is decreasing in rigidity R.17

Proposition 2 Expected political third-party opportunism costs E(T) are decreasing and globally convex in rigidity R.

The intuition that E(T) falls in R is that the likelihood of a successful TPO challenge can be reduced to negligible by extreme contract rigidity.18 Alternatively, E(T) can be seen as the public agent’s disutility of lack of contract flexibility.

From the third parties’ perspective, the realization of TPO benefits is also subject to the competitive environment. TPO costs borne by the incumbent public agent may not be internalized entirely by the challenger, but distributed to all third parties involved. We model third parties’ competitive environment with concentration parameter ζ ϵ (0, 1]. If ζ = 1, the TPO challenger’s benefits are symmetrical to the incumbent public agent’s TPO costs (bi-partisan or duopolistic market); if ζ < 1, the political market is oligopolistic and the challenger does not internalize all benefits from a successful contract protest.

Contract design (ex ante), and implementation and enforcement (ex post) costs are subject to contract preparation time, professionals (lawyers, engineers, consultants), documen- tation, and control needed, as well as discounted penalties due to deviations from contract at rigidity R. Penalties and part of these adaptation costs are borne directly by the contractor (Kpr) and reflected in the contract price, and part is borne only by the public agent (Kpu). We assume adaptation costs K—both public and private, and so contract price P—to be in- creasing in R. The slope of the K curve is a function of the marginal positive and increasing cost (effort) of adaptation—what Laffont and Tirole (1993, 307) call “processing costs”—and penalties at R.

Assumption 3 Adaptation costs K are strictly convex and monotonically rising in rigidity R, so thatloc-8-equation-3

The price P bid by the contractor is the sum of operating costs (company-specific), adap- tation costs for the private contractor (contract-specific subject to rigidity R), and a mark-up (economic profit). The contractor’s maximum bid price is P bud. To simplify our argument, we assume a uniform technology across firms and a competitive (or Bertrand competition) bidding market, such that P is the lowest possible cost subject to zero economic profit and follows private adaptation costs Kpr. We also assume away governmental opportunism, i.e., direct or incremental expropriation by the public agent.

2.4     Existence of an Internal Equilibrium

We define the following objective functions for the agents:

Bid price P equals Kpr  |  R, which also minimizes Kpu  |  R.  Expected third parties’ benefits from an opportunistic challenge are given by T0, ζ , and c and conditional on τ at R. If the challenge is realized (q = 1), expected third parties’ benefits equal T0ζ τ − c. The public agent  internalizes expenses related to the contract, i.e., at the end, she is accountable, directly or indirectly, for all costs borne.19 She has to pay contractors’ costs and her own costs, while aiming at minimizing political costs. The optimal level of rigidity R* is, therefore, driven by expected TPO costs, actual adaptation costs, knowledge about τ , and the public agent’s beliefs about ρ.

Given T0, T0, τ , c, ζ , and K , the equilibrium {q*, ρ*, R*, P *} is such that:

(a) R* = arg minR[T0ρ(R)τ (R) + K(P, R)]
(b) ρ* ≡ E(q* | R*) ≡ Pr[T0ζ τ (R*) > c(R*)]
(c) P* ϵ [Pmin, Pbud] = Kpr | R*

This solution can be achieved intuitively backwards. Starting from R*, any deviation from equilibrium makes the public agent worse off:

(a) If R < R*, then τ (R) > τ (R*), c(R) < c(R*), therefore ρ > ρ* and E[T(R)] − E[T(R*)] > K (P, R*) − K(P, R) (E(T) increase offsets gains in K decrease)
(b) If R > R*, then E[T(R*)] − E[T(R)] < K(P, R) − K(P, R*) (K increase outmatches gains in E(T) decrease)

Lemma 1 If  Assumption 3 and Proposition 2 hold and if  at low bound  rigidity  R,  the marginal expected third-party  opportunism costs E(T ) decrease is bigger than the marginal adaptation costs K increase, the sum curve of expected third-party  opportunism costs E(T ) plus adaptation costs K is U-shaped and has an interior  global minimum at R*.

If E(T) does not fall faster in R than K increases in R for low R states, TPO is irrelevant for the outcome of the contract (e.g., relational contracts). If TPO is a relevant hazard for the public agent, Lemma 1 implies that the optimal contract is partly flexible and of finite rigidity.   A too-flexible contract would be politically  too risky while an over-rigid contract would be too expensive. Figure 3 plots an example of expected third-party  opportunism costs E(T) falling in rigidity and specificity R, costs borne by the contractor Kpr and adaptation costs K rising in R, and the U-shaped sum of E(T) + K as the objective  function of the public agent minimizes.

loc-8-figure-3Figure 3. This graph plots expected third-party opportunism costs E(T) (red solid line) falling in rigidity and specificity R, costs borne by the contractor Kpr (blue dash line) and adaptation costs K (blue double-solid line) rising in R, and the U-shaped sum of E(T) + K (green dot line) as the objective function of the public agent minimizes. The contracting sets of price and rigidity  are given by the area above costs borne by the contractor Kpr and below the price budgeted by the public agent Pbud . Pmin is the equilibrium price in a competitive market for public contracts.

Corollary 1 In the presence of TPO, the sequential equilibrium public contract that mini-mizes political and contracting costs is rigid, ergo more expensive in its design, implementa-tion, and control than the theoretical first-best in the absence of TPO.

A direct outcome from Corollary 1 is that the higher E(T), ceteris paribus, the higher R* and P will be.

2.5. Endogeneity of Opportunistic Challenge

The endogeneity of opportunistic challenge provides contractual properties consistent with observations in the practice of public contracting:

(a) Larger contracts are associated with higher expected political benefits for opportunistic third  parties (higher mean µ) and, therefore, are associated with  higher likelihood of challenge ρ. Similarily, ρ increases in the proximity  to elections, since potential political gains are discounted at a higher discount factor

(b) Inherent public-private information asymmetries increase with complexity of transac- tions. The dispersion of third  parties’ beliefs about expected political benefits from an opportunistic challenge σ is higher in high informational asymmetry (low scrutiny) states and than in low informational asymmetry (“open accessibility”) states

(c) The more dispersed third parties’ beliefs about expected political benefits from an op- portunistic challenge is, lower cost of litigation  c leads to lower ρ and higher c leads to higher ρ

(d)  ρ is sensitive to the institutional  environment  determining τ  and c: the  higher τ , the higher ρ; the higher c, the lower ρ; the more τ decreases in R, the more ρ will fall in R

(e) The rule of law implies, ceteris paribus, higher ρ

(f ) The lower bound of ρ depends on the third parties’ priors, i.e., the propensity to litigation adherent to the institutional  framework

(g) Exogenous institutional  changes—e.g.,  new environmental norms, amendments to the legal system—alter τ  and c, and produce a new cumulative  probability  of challenge distribution, which will first-order stochastically dominate the former distribution when the legal system becomes more restrictive (i.e., an increase in clauses subject to challenge) or will be first-order stochastically dominated by the former distribution when the legal system is deregulated

2.6     Scrutiny:  A Two-Sided Sword

An increase in scrutiny—i.e., critical public observation and accountability through trans- parency and public participation—lowers the informational asymmetry between the actual political costs for the incumbent public agent and the third parties’ beliefs about the political benefits from an opportunistic challenge. First, an increase in scrutiny induces a calibration of beliefs about expected benefits from an opportunistic challenge (lower standard deviation), yielding a second-order stochastically dominant distribution  (see Figure 5), with the inflection point at the mean expected benefits (Mas-Colell, Whinston, and Green 1995, 197–199). Hence, all other things being kept constant (particularly,  mean expected benefits at low scrutiny µL equal to mean expected benefits at high scrutiny µH), an increase in scrutiny leads to an increase in the likelihood of challenge ρ at low litigation costs c and to a reduction in ρ at high c.

loc-8-figure-4Figure  4: This graph plots the likelihood of opportunistic challenge ρ for different levels of rigidity R, assuming the same distribution  functions of third parties’ expected benefits from an opportunistic challenge and the same cost of challenge  as in Figure 2.

Ameliorated transparency symmetrizes the information of the public agent  and third parties.  Consequently, the public agent  can better forecast third  parties’ reaction to her project and choice of R.  This prompts a counter-intuitive implication:  increased scrutiny increases third parties’ knowledge about the public agent and, thus, the public agent knows better what third parties know. This leads to a reassessment of the distribution of the public agent’s beliefs about benefits of opportunism for third parties T0.

loc-8-figure-5Figure 5: This graph plots the cumulative probability (y axis) of the public agent’s beliefs about third parties’ expected benefits from an opportunistic challenge (x axis): blue solid line for low scrutiny states and red dot line for high scrutiny states. It assumes rigidity  R = 10, a normal distribution  of benefits from an opportunistic challenge for third  parties T0  with µ = 30, σ = 20 for low scrutiny states and σ = 10 for high scrutiny states, τ = ln[exp(1) + R]−1 , and c = γR + 10, where γ = .2 and 10 are calibration parameters for an increase of c in R.  The likelihood of a TPO challenge ρ is the complementary cumulative probability  of the third  parties’ expected benefits from an opportunistic challenge being lower than the cost of challenge, i.e, ρ = 1 − Pr(T0 ln[exp(1) + R]−1  < γR + 10) = Pr(T0 ln[exp(1) + R]−1  − γR + 10 ≥ 0).  The distribution  function at high scrutiny (red dot line) second-order stochastically dominates the distribution  function at low scrutiny (blue solid line).  All other things being kept constant, an increase in scrutiny leads to an increase in the likelihood of challenge ρ at low litigation  costs c and to a reduction in ρ at high c.

Second, an increase in scrutiny updates mean µ of third parties’ beliefs about the benefits from an opportunistic challenge. If costs for the incumbent public agent were downwardly biased (underestimated) by third  parties (µL < µH ), benefits from an opportunistic challenge would be upwardly adjusted (first-order stochastic dominance given the same standard deviation); correspondingly, if costs for the incumbent  public agent  were upwardly biased (overestimated) by third parties (µL < µH ), benefits from an opportunistic challenge would be downwardly adjusted (see Figure 6).  The impact of an increase in scrutiny on contract features depends, therefore, on the adjustments in third parties’ beliefs. Neutral adjustments in beliefs lead to higher ρ, and thus higher R* for low litigation costs environments  and lower R* for high litigation  costs environments. Generally, an increase in scrutiny leads to public contracting efficiency (lower ρ, thus lower R* and P) with upwardly biased third-party  be- liefs, i.e., when the distribution  of third-party  beliefs about benefits from an opportunistic challenge at high scrutiny F (Ŧ)H  is first-order stochastically dominated by the distribution at low scrutiny F (Ŧ)L.  Likewise, high scrutiny regimes are inefficient (or not intended by the contracting parties) with downwardly biased beliefs.20

loc-8-figure-6Figure 6: This graph plots the cumulative probability (y axis) of the public agent’s beliefs about third parties’ expected benefits from an opportunistic challenge (x axis): blue solid line for low scrutiny states (µL = 30, σL  = 20), red dot line for high scrutiny states and neutral beliefs adjustment (µH = 30, σH = 10), green dash line for high scrutiny states and upwardly adjusted beliefs (µH = 35, σH = 10), and black dash-dot line for high scrutiny states and downwardly adjusted beliefs (µH = 25, σH = 10).  Upwardly adjusted beliefs (green dash line) first-order stochastically  dominate neutral beliefs adjustment  (red dot line).  Generally, an increase in scrutiny leads to public contracting efficiency (lower ρ, thus lower R* and P ) with upwardly biased third-party beliefs.

Furthermore, scrutiny increases the level of internalization of adaptation costs Kpu by the public agent and leads, ceteris paribus, to a gain in efficiency due to lower optimal contract rigidity  and contracting price. On the other hand, from calibration and update effects from scrutiny better informed third parties may increase or decrease the likelihood of TPO. Hence, it is equivocal whether open information policies (as the case of the  State of California21 or the State of Berlin22) lead to more efficient public contracts.

Proposition 3 Assuming away administrative scrutiny costs, an increase in scrutiny reduces R* only if the internalization of adaptation  costs by the public agent is larger than the increase of TPO costs due to calibration and update of beliefs by opportunistic third parties.

2.7    Political  and Market Structure

The model accounts for political and market structure.  If the political opposition is frag- mented, benefits from a challenge can go to any of the political competitors, not necessarily to the challenger who bears costs c; as ζ ≈ 0 (atomized political opposition), there will be no TPO challenges, which resembles a mono-partisan or autarky system.23

Analogously, a loser bidder will challenge a contract output only if the expected benefits Ŧ are higher than litigation costs c. In this case, ζ describes the challenger’s market structure: ζ = 1 for symmetrical Bertrand duopolies (one’s contractor losses are the gains for the other), ζ < 1 for oligopolies, and ζ ≈ 0 for perfect competition, where an individual competitor has no incentives to challenge a public tender outcome.

2.8    Designative Specifications

In the event that over-detailed specifications were designative, i.e., pointed to one or more particular bidders and precluded a competitive bidding market, they would be a source of TPO challenge of potential collusion or favoritism.

In this case, E(T ) is convex but not strictly decreasing in R, i.e., expected political TPO costs E(R) first fall in R and then rise in over-specificity R. If limR→0+< 0 holds
(see Appendix B.3), then designative  specificity is a sufficient  condition for finite optimal equilibrium rigidity  as shown in Lemma 1.

3. Contract Price Under  TPO

The public agent budgets—explicitly in tender information, announcements, or budget notes; or implicitly  in internal regulations—a maximum price P bud that she can pay the contractor.  The acceptable contracting price-rigidity sets for the public agent are below P bud, i.e., contracts “in  the  budget,” and subject to low TPO costs adjusted by R.  The contractor sees rigidity  R* and bids accordingly. On the contractor’s side, the acceptable price-rigidity sets are those above her private adaptation costs Kpr . Therefore, the contracting area—i.e., the sets acceptable  to both the public agent and the contractor—is given by price-rigidity combinations above Kpr and below Pbud. At a given R*, the minimum price required by the contractor is Pmin.  Figure 3 plots E(T) and K curves, optimal rigidity,  and budgeted and minimum prices.

Before the tender, especially in complex contracts, the public agent  only has an estimation of the contractor’s adaptation costs Kpr, but does not know them with certainty.  If P bud budgeted by the public agent is below the minimum acceptable price P<sup”>min = Kpr for the contractor at a given R*, then there will be no bidders or—in the case that P bud is not known by bidders prior to the tender—bidders will  bid P > P bud  and the tender will  be annulled.24  Therefore, “no contract” is a possible outcome if political risks are significant and budgeted  expenses are too low at a given rigidity.25 In this case, the tender will have to be redesigned at a lower rigidity  level at the risk of higher TPO for the public agent; the budget reconsidered, creating room for third-party  challenges attempting to control budget expenses; or terms negotiated after bidding, increasing TPO on suspicion of collusion.

4. Interrelation Between  Third-Party and Governmental Op- portunism

In this paper,  our goal was to highlight  third-party  opportunism implications for public contracting. The model, however, can also serve  to analyze the  impact of governmental opportunism (G) as a hazard to public contracts (Moszoro 2011; Spiller and Savedoff 2000; Troesken 1996).

The public agent  can administratively  expropriate sunk investments I borne by the private contractor. The private contractor assesses ex ante the likelihood ψ of expropriation loss A ≤ I .  The likelihood of governmental opportunism can be mitigated by restrictive contractual terms—additional rigidity—requested by the private contractor.  The residual expected governmental costs E(G) = ψ(R)A are imputed to private adaptation costs Kpr and further to price P min.
Proposition 4 In  the presence  of governmental opportunism, the private contractor will respond by seeking  further rigidity  R and charging an additional premium ψ(R)A  to her private adaptation costs Kpr .

Figure 7 presents a graphical representation of an increase in equilibrium rigidity  and price due to governmental opportunism.

Corollary  2 A corollary of the interrelation of third-party  and governmental opportunism is that higher price Pp due to governmental opportunism makes the contract more vulnerable to third-party challenges, or not feasible, if the Pp is above the maximum price Pbud that the public agent is willing or able to pay.

loc-8-figure-7Figure 7: This graph plots expected third-party opportunism costs E(T ) (red solid line) and expected costs of governmental opportunism E(G) (green solid-dot line) falling in rigidity  R, and costs borne by the contractor Kpr (blue dash line) and adaptation costs K (blue double-solid line) rising in R, and the U-shaped sum of E(T ) + K + E(G) (green dot line) as the objective function of the public agent minimizes. The contracting sets of price and rigidity  are given by the area above costs borne by the contractor Kpr and below the price budgeted by the public agent P bud . The equilibrium rigidity in a competitive market for public contracts with governmental opportunism rises from R* to Rt and the equilibrium price rises from Pmin to Pt.

The contractor’s taking out insurance against adverse political events (e.g., governmental expropriation, confiscation of assets, or repudiation of contracts) mitigates the expected costs of governmental opportunism, but shifts up adaptation costs K by the insurance premium. In a competitive insurance market, the political risk insurance premium equals the public agent’s expropriation rents expected by the insurer ES (G), while the contractor’s willingness to pay for political risk insurance equals her expected expropriation loss E(G). Political risk insurance will be beneficial for the public at large only if the political risk insurance premium, compounded now in the contract price, amounts to no more than the differential between contract prices with  and without  political  risk insurance, i.e., ES (G)  ≤ Pp − Pmin,  this differential being due to further rigidity  and the contractor’s expected cost of governmental opportunism at Rp. Political  risk insurance will  be cost-efficient  for the contractor if the political risk insurance premium is lower or equal to her expected cost due to governmental opportunism, i.e., ES (G) ≤ E(G).

Private contractors can only partially  insure themselves against governmental opportunism as it cannot be managed and insurers want to avoid moral hazard on the investors’ side. Similarly, would the public agent  know that  the investor has insurance, it increases the incentive to misbehave  as it will trigger less opposition. If political risk insurance premiums are too low, contractors that face opportunistic-type governments will lower rigidity and take out insurance—moral hazard—triggering more governmental opportunism and further increasing claims.

Advancing this result, the insurer will increase political risk premiums. If political risk insurance premiums are too high, it will not be cost-efficient for contractors of non-opportunistic-type governments to take out political risk insurance. In equilibrium without informational asymmetry on the government type, bankruptcy constraints, and risk neutrality,  contractors will  be indifferent about taking out political risk insurance. In the presence of informational asymmetry about the likelihood of governmental opportunism ψ, limited liability,  and risk aversion, an adverse selection screening game—largely  described in the literature  on insurance markets—will take  place, which explains high political risk insurance premiums, the existence of tiny  private markets for political risk insurance,  and the indispensable involvement of multilateral agencies (MLAs).26

5. Applications  and Supportive  Evidence

The TPO model attends to standard public procurement.  Nonetheless, it encompasses a wider range of public contracting praxes and can be conductive  to the understanding of mechanisms in public management  and efficiency. We  now apply the TPO framework to specific settings to derive empirical implications.

5.1    Bureaucracies

Civil  servants are subject to more rigid contracts (e.g., regulated hiring, list of duties and responsibilities) than their peers in the private sector.27 A private company can hire whoever it wants and a typical employment contract may simply say “follow the instructions of your principal,” while in most jurisdictions the process of employment of civil servants in public in- stitutions is highly formalized and procedural, and responsibilities are detailed in civil service laws and internal regulations of the agency, department, office, and section in question (Horn 1995, 20, 88, 112), and subject to independent ordinary and extraordinary controls (Horn 1995, 98).28 Both specific employment procedures and rigid contracts in the civil service are aimed at avoiding challenges of favoritism (Horn 1995; GAO 2003), but nonetheless result in civil servants being allowed less discretion, less initiative in bringing solutions, and lower productivity29  (analogous to higher price in public tenders). TPO thus provides a consistent explanation of civil service inefficiencies that is broader than the public administration view on red tape.30

Bambaci, Spiller, and Tommasi (2007) describe the Argentine bureaucracy  as a combina- tion of constitutional protections of civil servants, relatively low wages,31 and low accountability to “short-lived” political public agents,32 which produces unresponsive bureaucrats with few incentives to invest in their own capabilities. Precisely  because political public agents do not last long, TPO is not a prevalent hazard for them. The institutional  adaptation that emerged is the large use of a “parallel  bureaucracy,”33 i.e., temporary contracted profes- sionals, better paid, more responsive to their principals, under a more flexible regime than permanent bureaucrats, and whose appointments are left to the discretion of the principal public agent in office (Iacoviello and Tommasi 2002; Bambaci, Spiller, and Tommasi 2007). Thereby, political public agents in Argentina blend permanent bureaucracy with temporary bureaucrats who respond more flexibly and efficiently.

5.2    Fixed-Price  vs. Cost-Plus Contracts

In theory, fixed-price contracts are preferable when the adverse selection problem decreases relative to the moral hazard problem (e.g., in the procurement of standardized goods and services, or in projects involving a low level of informational asymmetry between the contract- ing parties), while cost-plus procurement is preferable in complex projects when the adverse selection problem increases relative  to the moral hazard problem (i.e., when uncertainties related to technological requirements are unknown and bigger than the inefficiencies arising from incomplete monitoring and insulation of the contractor from cost overruns).34

In practice, cost-plus  contracts have been criticized by the Obama administration for frequent and substantial cost overruns in government contracting.  A GAO (2008) study of 95 major defense acquisition projects found cost overruns of 26 percent, totaling $295 billion over the life of the projects. Cost-plus contracts are more adaptable, but also abusable35  and shading (Fehr, Hart, and Zehnder 2011). The Presidential Memorandum of March 4, 2009, for the Heads of Executive Departments and Agencies on Government Contracting, explicitly stated that “there shall be a preference for fixed-price type contracts. Cost-reimbursement contracts shall be used only when circumstances do not allow the agency to define its re- quirements sufficiently to allow for a fixed-price type contract.”36

Procurement laws normally allow public agents the design of public procurements based on a menu of price, technical, and quality criteria. Public agents are given discretion regarding the choice of criteria and the weights of those criteria in the final decision scoring. There is, however, a strong affinity for the price criterion when accountability  and scrutiny, and attached to them political hazards are high. In France, only 2 percent of all public tenders include soft clauses.37  In pre-EU Poland, most of public contracts where tendered based on a menu of objective and discretionary criteria: 39 percent of public tenders where based on the lowest price bidder single criterion in 2001 and 2002, 51 percent in 2003, and only 29 percent in 2004.

The lowest price bidder as the single criterion increased to 53 percent in 2005, 64 percent in 2006, 87 percent in 2007, 84 percent in 2008, 90 percent in 2009, and 91 percent in 2010 (Jarzyn´ski 2011, 17). According to analysts, this preference for fixed-price bidding was the result of increased frequency, complexity, and profundity of controls after Poland’s joining the European Union.38  Public agents preferred to include technical and quality parameters in specifications and rely on the more “objective, clear, and accountable”—less contestable— price criterion for bid selection to avoid political risks.

Fixed-price contracts do not provide adaptable risk-sharing mechanisms and may lead to an unintended increase in government payments.39 In the presence of closer third-party oversight and fear of TPO,40  public agents will prefer fixed-price contracts in settings where cost-plus contracts could prove to be more efficient. Our result that larger (and thus more complex) projects lead to more restrictive terms of contracting seem counter to the extant literature that cost-plus is preferable for complex projects.

5.3    Public-Private Partnerships

Public-Private Partnerships (PPPs) are public service businesses operated under long-term agreements with private providers. Beside fiscal motives, they are aimed at gaining efficiency from the private sector’s technical and managerial advantage through innovation and flexi- bility.  Flexibility,  however, makes PPPs vulnerable to third-party  challenges (higher ρ). To limit the scope of ex post challenges from third parties, public agents control outputs through Key Performance Indicators (KPIs), i.e., measures under which the contractors are evaluated. At the same time, KPIs constitute a signal for the public at large that the service, although privately provided, remains publicly accountable. KPIs are thus crucial to curb third parties’ ability to challenge PPPs. Nevertheless, the failure of many (potential) PPPs can be rooted in high adaptation costs K imposed on private contractors.

A number of Australian studies of private investment in infrastructure reached the con- clusion that, in most cases, the PPPs were inferior—overall more expensive for the public or delivered lower quality of services—than the standard model of public procurement based on competitively tendered construction of publicly-owned assets. One response by public agents to these negative findings was the development of formal procedures for ex ante assessment of PPPs using the Public Sector Comparator (PSC) and Value-for-Money (VfM) methodologies, i.e., introducing more contractual ex ante specificity and contractual costs.41

In 2009, the Treasury of New Zealand, in response to inquiries by the new National Party government, released a report on PPPs that came to the conclusion that “there is little reliable empirical evidence about the costs and benefits of PPPs” and that “the advantages of PPPs must be weighed against the contractual complexities and rigidities they entail.”42

PPPs were introduced to bring private management practices to the public sphere and over time became closer to regulation.  In the presence of TPO, public agents will pursue private provision of public goods only in projects where expected gains from contract flexibility  and better private management offset the increase of costs of compliancy with ex ante cost-benefit assessment and ex post KPIs.

5.4    External  Consultants and Certification  of Contractors

The engagement of independent consultants (e.g., multilateral agencies, international advis- ers, especially in countries with weak legal systems) strengthens the objectivity of procurement processes and prevents third-party  challenges that cooperation  between public agents and private contractors has crossed the line and become collusion.

Moszoro and Krzyzanowska (2008) report the employment of external consultants in the city of Warsaw in the pre-procurement planning phase when it wanted to introduce novel PPP contracts: firstly, to overcome the lack of expertise in complex contracting (to reduce K) and, secondly and most importantly, to “safeguard the city authorities against complaints and criticism by subsequent administrations.”  While the city authorities could have designed the tender process in-house, they seem to have outsourced it to reduce TPO. The use of external consultants, however, came at a cost: PLN 10 million ($3.2 million), i.e., 1.2 percent of the estimated budget for those projects.

Similarly, certain public tenders require certification of contractors and sub-contractors, increasing contract specificity and the price of the tender. In May 2010, a public procurement for the “Canal Safety and Drainage Improvements Project” in Antioch, Pittsburg, Bay Point, Clyde, and Walnut Creek (California), tendered by the Contra Costa Water District  Construction Department, was objected to by JMB Construction.43  JMB Construction argued that the apparent low bidder Con-Quest Contractors included a non-certified subcontractor. According to Contra Costa Water District  Construction Department, the relevance of the works the alleged sub-contract would provide was minimal for the project overall; however, the challenger argued that the inclusion of a non-certified subcontractor allowed Con-Quest Contractors to bid a lower price ($756,000 compared with JMB Construction’s $852,000, i.e., 11 percent cheaper) than if it had included only certified subcontractors.44 Furthermore, if required “red-tape” certificates exclude qualified bidders and prevent competitive bidding, the market structure will become more oligopolistic and additional dead-weight inefficiencies will add to the final equilibrium price.

In both cases—the  use of external consultants and certification of contractors—the im- plicit aim is to lessen the likelihood of TPO challenge ρ. There is a trade-off for the public agent between lower TPO hazards and additional contracting costs K of external consultants and certification.  The public agent will employ external consultants and certification when additional contracting costs K incurred are lower than price gains in contract flexibility  due to lower E(T) and R*.

5.5    Efficient Small Communities and Authoritarian Regimes

Small local governments (towns, counties) can be more efficient in public contracting than larger governments (metropolises, states). Due to the lower value of the contracts compared with larger governments, the benefits from political challenge are relatively low.  Thus, the likelihood of challenge is lower and subsequently potential TPO costs are lower. The public agent can therefore engage in more discretionary contracts and incur lower transaction costs.
Coviello and Gagliarducci (2010) present a study covering 3,825 Italian  municipalities and 27,537 auctions, where an increase in the mayor’s tenure of one term is associated with fewer bidders per auction (–23.28 percent), a higher probability that the winner is local (+3.20 percent) and that the same firm is awarded repeated auctions (+25.52 percent), i.e., more discretionary contracting (lower R*) correlated with longer tenure. They also find evidence that a high level of heterogeneity within the government coalition reduces the possibility of favoritism in shaping the procurement process, that less “colluded”45  mayors are more likely to be reelected and survive longer, and that citizens and competitors are more likely to closely monitor large public projects.

Two reasons can be given why mayors with  longer tenure show a low concern about TPO and contract discretionarily.  First,  the Italian  electoral system in municipalities is a simple majority  regime. Consequently, in small municipalities, high political contestability (low ζ ) results in dispersed voting and a relative advantage for incumbent mayors.46 Second, procurement protests in Italy  go through courts, where penalties for breaking procurement laws are rarely enforced (low τ).47 When K increases in R more rapidly than E(T) decreases in R, or when E(T ) are irrelevant due to lack of political contestability (as seems to be the case in Italian municipalities), the outcome is discretionary procurement.

Authoritarian  regimes, where the likelihood of challenging the incumbent public agent is low, can contract public works more discretionarily and, thus, cheaper and quicker. The lack of chances for TPO can help to explain the rapid development of infrastructure in Paraguay during the Stroessner regime.  Molinas, Pérez-Liñán,  Saiegh,  and Montero (2006, 12–13) report the significant ability of the regime “to reap the benefits offered by long-term economic opportunities.   (…)   [Development  programs were] possible because  of the intertemporal ‘cooperation’ of the key actors (the government, the Party,  and the Armed Forces). The adaptation of the development model to allow for increasing integration with Brazil would have been unlikely under short-lived governments like the ones characterizing the post-Chaco war period (1936-1954). During that 18-year period, there were 12 different presidents, and political volatility prevented an adaptation to changing economic environments.  (…) During the 1960s and the 1970s, Paraguay built roads, silos and, most importantly, the biggest dam in the world, the Itaipu´ Hydro-electric Dam, built jointly with Brazil. The long-term growth strategy turned out to be effective. During the 1960s, real GDP growth was 4.2 percent. During the 1970s, Paraguay had one of the highest growth rates in the region, with  real GDP increasing at 8 percent over the decade.” That ability  to move policy decisively and effectively by an authoritarian regime, however, also funneled most of the benefits from this fast development period to a few contractors and subcontractors—companies  owned by the dictator’s followers (Fogel 1993, 16).

5.6    Privatizations  of Government-Owned  Companies

Privatizations of government-owned  companies48  are usually subject to clauses of commit- ment  by the private acquirer concerning labor retention, modernization processes,  future investments and other social sensitive issues. On the one hand, rigid privatization contracts (high R*) take  place in the fear of TPO challenges to the incumbent  public agent  by la- bor unions, the local community, and the political opposition.  In order to minimize TPO challenges to privatizations, public agents embed clauses and golden shares in privatization contracts that  allow them to limit  “cream skimming” (Kolderie 1986) and the discretion of the private investor.

On the other hand, such privatization clauses limit the company’s governance and, consequently, lower its value (analogous to a high price in a public procure- ment).  If the revenue to the public budget from privatization is low, the public agent can be accused of collusion with the private agent or of “selling off the family silver” (Kolderie
1986). The corollary is that privatizations’ aftermath regarding price and efficiency appears to be a sell-off from a government’s valuation standpoint and rigid from a private managerial perspective.

6. Concluding Remarks

Our approach combines political hazards and transaction costs to explain apparent inefficien- cies in public contracts. High ex ante payment volatility  or ex post flexibility  in implemen- tation may trigger drawbacks, leading to contract failure or costly adaptation by the public official, whether in terms of time or political career. A paramount conclusion of our analysis is that public contracts cannot be directly compared to private contracts. Instead, they can only be compared to analogous public contracts,  and should pass Williamson’s “remedia- bleness criterion,”  which holds that “an extant mode of organization for which no superior feasible alternative can be described and implemented with expected net gains is presumed to be efficient” (Williamson 1999, 316; the emphasis is original), to attest to their efficiency.

The fact that public contracting is more expensive and rigid than private contracting, however,  does not mean that transferring those activities to the public sector would reduce political risks and hence make them more efficient. Public procurement is used for “hard” agency problems where consumers cannot be trusted and “when bureaucracies work poorly, [but] consumer choice works worse” (Prendergast  2003, 930–933). Not only, as Williamson (1999, 320) discusses, do certain transactions have special needs for probity and require the security of the State, but the privatization of public functions itself involves TPO hazards, making them less preferable  for public agents than public contracting itself.

In this paper, we have analyzed public procurement in a variety of environments to show that much of its outer features can be understood  as political adaptations to the fundamental hazard of third-party  opportunism prevalent in public contracting.

Appendix A Notation

loc-8-appendix-a

Abbreviation     Meaning
DoD    U.S. Department of Defense
GAO    U.S. General Accounting Office
MLA     Multi-Lateral  Agency
TPO     Third-Party  Opportunism

Appendix B Proofs

Appendix B.1    Proof of Proposition 1

Third parties’ choice of opportunistic challenge  q is such that q = 1 iff expected returns to TPO are positive, i.e., T0ζ τ (R) > c(R). From the public agent’s perspective ρ is the expected value of the random realization of q:
loc-8-appendix-b1

Appendix B.2 Proof of Proposition 2

Let F (T0) ~ N (µ, σ2) be the twice differentiable normal distribution of T0 with mean µ and standard deviation σ. From the linear transformation property of normal distributions, let ƒ T0ζ τ − c; ζ τ µ − c, (ζ τ )2σ2 .
E(T) decreases in R—From Proposition 1:

loc-8-appendix-b2-1E(T ) is locally convex in R:

loc-8-appendix-b2-2S e e E q  6
Differentiating Equation 3 with respect to R:

loc-8-appendix-b2-3Replacing Equation 6 in Equation 5:

loc-8-appendix-b2-4E(T ) is globally convex in R—From Assumption 1 and Proposition 1:

loc-8-appendix-b2-5

Appendix B.3 Proof of Lemma 1

loc-8-appendix-b3

Appendix B.4 Proof of Corollary 1

This proof follows from Lemma 1 and the discussion provided in the text.

Appendix B.5 Proof of Proposition 3

(a) Let αL, αH  ϵ (0, 1) be the level of internalization of contracting costs by the public agent, where αL < αH , αL represents low internalization for low scrutiny states of the world and αH  represents high internalization for high scrutiny states of the world, and αL,H K are third-party  contracting and enforcement costs accounting for scrutiny

(b)  An increase in scrutiny from αL to αH  leads to an increase in the internalization of direct and indirect expenses by the public agent, i.e.,  loc-8-appendix-b5-b(c) In comparative statics, if Proposition 2 and Assumption 3 hold, and for any given Kpr , an increase in the level of internalization of contracting costs by the public agent (αL → αH ) leads to a decrease in the optimal rigidity (R*L  > R*H ), thus—ceteris paribus —lower R* leads to lower Kpr and lower Pmin   due to monotonicity and strict convexity of E(T) in R

(d)  Let βL, βH   ϵ (0, 1) be  the types  of informed third  parties from scrutiny,  where βL represents low informed types  for low scrutiny states of the world and βH   represents high informed types  for high scrutiny states of the world, and ρβ is the likelihood of third-party  challenges accounting for scrutiny

(e) loc-8-appendix-b5-e

(f ) Depending on the type of informed third parties, ρβ may increase in scrutiny (βL < βH , i.e., downwardly biased third  parties) or decrease in scrutiny (βL > βH , i.e., upwardly biased third parties)

(g) If βL > βH , every increase in scrutiny leads to a decrease in R* and Pmin

(h)  If βL < βH , an increase in scrutiny leads to a decrease in R* only if loc-8-appendix-b5-h

Appendix B.6 Proof of Proposition 4

Let I be sunk investments and A be the rents of the public agent from expropriation (where A = I represents total expropriation and A < I represents partial expropriation) and ψ the likelihood of governmental opportunism of appropriating A. Expected costs of governmental opportunism equal E(G)  = ψ(R)A,  where ψ is assumed to decrease  in contract rigidity Aψ/AR < 0).

For any ψ > 0, the higher sunk investments I are, the higher possible expropriation rents A and expected costs of governmental opportunism E(G) will be, ergo the private contractor will demand higher contract rigidity  Rp > R* and higher final price Pp  > Pmin.

Appendix B.7 Proof of Corollary 2

Proof provided in the text.

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Endnotes

1 What Williamson (1999, 311) calls the hazard of probity posed by transactions organized in the public sector.

2 As Goldsmith and Eggers (2004, 122) underscore, “when something goes wrong in a public sector network, it tends to end up on the front page of the newspaper, instantly transforming a management issue into a political problem.”

3 Williamson (2005, 3) defines governance as “the means by which to infuse order, thereby to mitigate conflict and realize mutual gains.”

4 Acknowledging that hierarchies and procurement are “alternative methods of coordinating production” (Coase 1937, 388).

5 Not only though the price system, but also as a managerial decision.

6 The need to incorporate insights from law, political science, and sociology to understand what the rough price theory cannot fully capture.

9 In this regard, contract rigidity is the opposite of a “best efforts” clause.

10 See the DoD’s (2011) memorandum on “Source Selection Procedures,” issued on March 4, 2011, and effective July 1, 2011. Available at: http://www.acq.osd.mil/dpap/policy/policyvault/USA007183-10-DPAP.pdf (accessed May 19, 2011).

11 See Appendix A for a glossary of notation.

12 Marshall, Meurer, and Richard (1994a) sustain that allowing excluded bidders to challenge the outcome of a procurement process inefficiently reduces solesourcing.

13  Maser, Subbotin, and Thompson (2010) study the efficiency of the bid-protest mechanism in the US. In underlining “fairness” in contracting, i.e., that  giving equal treatment to “all  potential suppliers matters, not only to winners, but to losers as well” (Maser, Subbotin, and Thompson 2010, 2; their emphasis), they characterize the challenger  as a loser bidder and focus on the transaction-cost side of TPO, ignoring the political context of public agents. They make this point more explicitly , recalling the rule-of-law doctrine: “official duties are supposed to be defined primarily by neither instrumental  aims nor political  pressure, but by law” (Maser, Subbotin, and Thompson 2010, 3).

14  R = 0 denotes the minimum rigidity to avoid opportunism hazards inherent to relational contracts.

15  We use the term “likelihood” instead of “probability” to underline that we refer here to singular public contacts. The likelihood of third-party challenge and the success of the challenge can be compounded, since what makes a challenge actual is its likelihood of success (the likelihood of third-party challenge ρ increases with the likelihood of success of a challenge τ). Every challenge has some probability of success; otherwise the challenger would lose resources and reputation.

16  E.g., highway repair generates significant negative externalities for commuters through increased gridlock and commuting times.  Lewis and Bajari  (2011, 2) take the example of Interstate  35W, a main commuting route in Minneapolis carrying over 175,000 commuters per day. If a highway construction project results in a 30-minute delay each way for commuters on this route, the daily social cost imposed by the construction would be 175,000 hours. If we value time at $10 an hour, this is a social cost of $1.75 million  per day. Most public contracts affecting the public at large, from sewage disposal to worse service because of a delay in buying IT equipment, carry externalities.

17 Proofs are presented in Appendix B.

18 The type of specifications we deal with is non-designative, i.e., they do not point to any particular bidder and do not preclude a competitive bidding market. The particular case of designative specifications is developed in Subsection 2.8.

19 See Subsection  2.6 for a treatment of different levels of internalization  of contracting costs.

20   An  example where the public-private  contracting  parties plausibly  benefited from low scrutiny  and downwardly  biased beliefs was reported by the Financial  Times :  “Royal  Dutch  Shell and other  natural resources companies have stepped up efforts to counteract planned anti-corruption rules that  would force them to disclose payments to governments in countries where they operate. The Anglo-Dutch group, Europes largest oil and gas company by market capitalization,  has put forward a series of alternatives, arguing that the current proposals will  have ‘limited  impact and unclear benefits.’ The new requirements for US and EU quoted businesses are designed to highlight regimes that receive large sums from selling oil, gas, minerals and forests but then siphon off the proceeds rather than reinvest locally for public benefit. The EU has proposed a series of amendments to existing rules on transparency, including detailing payments on a project-by-project basis. The unions Competitiveness Council meets this week to agree a general approach.” See: Andrew Jack and Sylvia Pfeifer, “Shell joins push to dilute EU’s proposed anti-corruption rules,” Financial Times, February 20, 2012, p. 17.
Conversely, Italy’s government published details of the income and wealth of all its ministers on February 21,

2012, in a step aimed at boosting transparency and public trust in officials and, arguably, adjusting upwardly biased beliefs and preempting third  parties’ opportunistic  challenges. See: Giulia  Segreti, “Rome unveils details of ministers’ wealth,”  Financial  Times, February 22, 2012, p. 3.

21  The California  State Legislatures Brown Act  of 1953 guarantees the public’s right to attend and participate  in meetings of local legislative bodies. The Brown Act  solely applies to California  city  and county government agencies, boards, and councils.

The Bagley-Keene Open Meeting Act of 1967 implements a provision of the California Constitution which declares that  the meetings of public bodies and the writings of public officials and agencies shall be open to public scrutiny, and explicitly  mandates open meetings for California State agencies, boards, and commissions. The Act facilitates accountability and transparency of government activities and protects the rights of citizens to participate in state government deliberations.

The California Public Records Act of 1968 mandates disclosure of governmental records to the public upon request, unless there is a specific reason not to do so. According to Article 1 of the California Constitution  due to California Proposition 59 (the Sunshine Amendment) “the  people have the right of access to information concerning the conduct of the peoples business.”
For all California State Legislature Acts, see http://www.legislature.ca.gov/.

22   According  to  the  amendment  of  the  Freedom of  Information   Act  of  the  State  of  Berlin  of  July 2010,  all  contracts  have  to  be  made available  to  the  public  (see http://www.berlin.de/sen/finanzen/ and Alexander Dix,  2011, “Proactive Transparency for Public Services:  the Berlin Model,” http://www.freedominfo.org/2011/10/proactive-transparency-for-public-services-the-berlin-model/; accessed December 5, 2011).  The primary  subject of this  Act  is the access  to  contracts on the delivery  of basic public services to which the State of Berlin and private investors are parties. Additionally, in February 2011 the State of Berlin  was forced by referendum to unconditionally  disclose all contracts, decisions, and side agreements associated with  the partial  privatization of the Berlin  Water  Utilities  and closed between the State of Berlin and the private shareholders:   see “Act for the full disclosure of secret contracts for the partial privatization of the Berlin Water Utilities,” as of March 4, 2011, (GVBl.  p. 82).

23  Argentina’s President Cristina Kirchner does not hold councils with the Board of Ministers nor organize press meetings, and closes the doors to dialogue with  the politically  fragmented opposition. See: Carmen de Carlos, “El  caudillaje de Cristina Kirchner (I),” ABC, Barcelona, February 19, 2012, pp. 36–37.

24    In   October  2011,  the  regional  government   of  Lower  Silesia,  Poland,   assigned PLN   12  mil- lion  for  road  renovation  and  maintenance. Meanwhile,  it received bids  ranged  from  PLN   46  million   to   PLN   115  million. Similarly,    the   city   of L- o´d´z,   Poland,   which   planned  to   spend  PLN 201  million    for   a   stadium,   received  bids   ranged  from   PLN   218  million    to   PLN   322  million. See: http://www.umwd.dolnyslask.pl/transport/aktualnosci/artykul/o-planach-zwiazanych-z-partnerstwem- publiczno-prywatnym-1/ (accessed January 26, 2011).

25   Scarce budgeted expenses  for transport  infrastructure  along with  excessive  contract  rigidity due to continuous TPO  can explain the paralysis in highway development  in Poland during  the last decade. See “Poles repositioned,” Project Finance Magazine, October 23, 2010.

26  See, for example, the Multilateral Investment Guarantee Agency (MIGA), a member of the World Bank Group (http://www.miga.org/; accessed July 15, 2011), or the Overseas Private Investment Corporation (OPIC),  a U.S. Government’s development finance institution (http://www.opic.gov/insurance; accessed July 15, 2011).

27  In this instance, bureaucrats as individuals are the private party contracting with the public agent.

28  For example, controls may be overseen by the Government Accountability Office in the USA, the Australian National Audit  Office in Australia,  the Tribunal  de Contas da União in Brasil or the Bundesrechnungshof in Germany, to name a few.

29   According to the British  Office for National  Statistics  (ONS),  public  sector productivity fell  by 3.4 percent in 1997-2006, compared with  a rise of 28 percent in the private sector over the same 10-year period (see Robert Watts, “Public  sector pay races ahead in recession,” The Sunday Times, January 3, 2010).

30  See Bozeman (1993).  See also Laffont and Tirole  (1991), Pfiffner (1987), and Spiller and Urbiztondo (1994).

31  In 1999, Federal Government wages divided by GDP per capita equaled 1.65 in Argentina,  compared with 3.70 in Brazil, 3.25 in Colombia, 3.05 in Chile, and 1.99 in Mexico. See Carlson and Payne (2003).

32  The low accountability  of the Argentinian  administration  is to a large extent due to the high turnover of political  public principals:  ministers, secretaries, and undersecretaries of state.  For instance, the average tenure of Ministers of Finance in 1950-1989 was 1 year, compared with  2.4 years in developed countries and 2.0 in developing countries (Bambaci, Spiller, and Tommasi 2007, 165).

33  In 1998-1999, parallel bureaucrats accounted for 17 percent in the Presidency office, but 63–88 percent in ministries (see “Estudio  exploratorio sobre la transparencia en la Administración Pública Argentina:  1998-1999,” Oficina Anticorrupción,  Ministerio  de Justicia, 2000, cited in Bambaci, Spiller, and Tommasi 2007, 172).

34  See Loeb and Surysekar (1994).

35   Cost-plus contracts are seen  as a “blank  check”  for contractors and the root  cause of procurement inefficiencies.  A  notable exception is the case of London’s Heathrow Airport Terminal  5, which was de- livered on schedule and under budget, under a cost-plus regime (see http://www.airport-technology.com/ projects/heathrow5/ (accessed July 10, 2011).

36  See Presidential Memorandum of March 4, 2009, for the Heads of Executive Departments and Agencies on Government  Contracting,  retrieved from http://www.whitehouse.gov/the press office/Memorandum-for- the-Heads-of-Executive-Departments-and-Agencies-Subject-Government/ (accessed July 11, 2011).

37  See: http://www.ngo.pl/x/686690.

38  Poland entered the European Union on May 1, 2004, which can be considered a transition  year.

39    See  also Tony  Purton,   “The   case for  a  return  to  ‘cost  plus’,”   Defense Viewpoints,  March  24, 2007, http://www.defenceviewpoints.co.uk/articles-and-analysis/the-case-for-a-return-to  cost-plus (accessed July 10, 2011). Flyvbjerd,  Holm, and Buhl (2002) report costs underestimation in 9 out of 10 transport  in- frastructure projects: actual costs were 45 percent higher than planned in rail projects, 34 percent in tunnels and bridges projects, and 20 percent in road projects.

40   As stated in  the Presidential  Memorandum (op.   cit.),  “reports  by agency Inspectors General, the Government  Accountability Office (GAO),  and other independent  reviewing bodies have shown that  non- competitive  and cost-reimbursement  contracts have been misused, resulting  in wasted taxpayer resources, poor contractor  performance, and inadequate accountability  for results”  and “improved  contract  oversight could reduce such sums significantly” (emphasis added).

41  See, for example, the Department of Treasury and Finance of Victoria’s (2001) technical note on PSC.

42  Brian Rudman, “Promised electric trains derailed by misguided enthusiasm.” The New Zealand Herald. June 1, 2009. Emphasis added.

43  See http://www.ccwater.com/buscenter/109067\ results.pdf (accessed May 28, 2010).

44  Based on an interview held in May 2010 with a Contra Costa Water District engineer.

45  Coviello and Gagliarducci (2010, 26–27) argue that mayors’ time in office leads progressively to a long- term relation (“collusion”) with a few favored bidders, and propose two interpretations:  one based on favoritism and bribes  in  procurement, and another based on a learning process  of by mayors about  the quality  of contractors and a preference for higher-quality contractors.

46  If m is the population and n the number of candidates, a candidate needs m/n + 1 votes to win the election.

47   During  the period 2005-2008, the Italian  central purchasing authority CONSIP made 4,095 random inspections on the ex post renegotiations of procurement  contracts for goods and services, and found a to- tal  of 1,455 contractual  infringements.  Only  4 percent  of the associated penalties were paid (Coviello and Gagliarducci 2010, 27). In Italy  in 2009, the average waiting time for a bid protest first instance hearing was 18 months (European Commission 2011). Furthermore,  anecdotally, then it takes on average more than 10 years for juries to come to a verdict on bid protests.  How public contracting  can actually take place in an environment in which penalties are seldom paid remains a subject of future research.

48  PPP and privatization differ in that the former is a transfer to the private sector of a right (which may or may not come with  a physical asset) to perform the public function, while the latter  usually refers to the sale of an asset which is not necessarily idiosyncratic to the public sector (e.g., liquor stores in Pennsylvania).

 

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