Buyer-seller transactions are often governed by competitively-awarded procurement contracts. The use of competition to assign contracts can be a powerful tool to reduce prices. However, it could also allow under-qualified contractors to win, leading to a worse execution.
In the BSE Working Paper 1327, “Competition under Incomplete Contracts and the Design of Procurement Policies,” Rodrigo Carril, Andres Gonzalez-Lira, and Michael S. Walker study the equilibrium effects of enhancing competition for procurement contracts in prices and execution quality. By focusing on the U.S. Department of Defense, the authors provide empirical evidence on this trade-off to later develop an equilibrium model of competition for contracts.
The Empirical Set Up
The paper focuses on the Department of Defense since it represents a sizable fraction of the U.S. economy, given that it awards $500 billion in contracts per year. Also, the detailed administrative data allows for tracking each contract from design to execution, providing the perfect measure for performance.
The empirical strategy exploits regulation that requires agencies to publicize contract opportunities expected to exceed $25,000 in value through a centralized online platform. By focusing on contract awards between $10,000 and $40,000, the authors exploit the discontinuous nature of the requirement to estimate the effect of contract advertisement on different outcomes. Overall, they find that advertised contracts see an increase in the number of bids of roughly 60%, therefore increasing competition. This leads to a trade-off. On the one hand, advertised contracts have 6% lower prices on average. On the other hand, they result in worse ex-post performance, with a 7% higher probability of overruns and an 8% higher probability of delay. This can be seen in Figure 1, where contracts above the threshold have worse performance. Finally, competition also affected the firms’ characteristics, with winning firms being 14% less likely to be small businesses and located 60% farther from the buying agency.
With the evidence at hand, the authors develop and estimate an equilibrium model of competition for procurement contracts. The model consists of four stages that cover the different phases of the procurement project. First, the buyer decides on the degree of competition by advertising or not the contract. Then, firms that receive information about the contract decide or not to prepare a bid. Third, bids are submitted depending on production cost. Finally, the awarded contractor executes the contract.
By specifying the selection process that leads to buyers’ publicity choices, the model allows extrapolating the local effects estimated at the policy discontinuity to the full sample. Overall, the findings of the model are consistent with the reduced-form evidence suggesting the model fits the data correctly.
The authors can now use the model to address different policy implementations and analyze their effects. They find that delegating the advertisement decision to the buyer increases the overall welfare when transactions are complex. However, when transactions are simple, the best outcome is achieved when competition is always increased, since the risk of poor execution is lower.
Overall, they conclude that simple adjustments to the current regulation could reduce by 2 percent procurement spending, which is equivalent to $104 million annually.