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EC 307: Economic Policy in the UK Week 14: More Competition.

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Presentation on theme: "EC 307: Economic Policy in the UK Week 14: More Competition."— Presentation transcript:

1 EC 307: Economic Policy in the UK Week 14: More Competition

2 EPUK Lecture 42 Entry deterrence, predation An English reverse auction with n+1 bidders and no reserve price gives a lower expected fee than an English auction with n bidders culminating in an optimal final take-it-or-leave-it offer to the last bidder. This hold for affiliated signals if ME is upward-sloping. The auction with a final ultimatum is not optimal if signals are affiliated, but is best among mechanisms where –Losers get nothing and –In equilibrium any winner has the lowest signal and –Winner’s fee is weakly increasing in his own signal for any realisation of others’ signals. Even with affiliation, the expected fee from an English auction with no reservation price is the expected ME of the winning bidder. Similarly, the expected ME of an English auction with an optimal reserve price is the minimum of the lowest bidder’s ME and C +. In general, bidders’ costs and MEs are not independent of others’ signals. Thus MEs in a n-bidder auction are different from the same bidders’ MEs in an n+1 bidder auction. Nonetheless, it can be shown that any n+1 bidder auction with no reserve is more profitable than any standard n- bidder auction.

3 EPUK Lecture 43 Collusion Explicit collusion: 2PSB more favourable than 1PSB (harder to cheat) Phases of the Moon scandal – concealing information from the buyer. How to pick ‘winner’ and divide spoils? Use a pre-auction to: –Establish identity of winner (usually, want efficient result) –Set ‘winning’ bid – depends on whether cartel covers industry. –Need to establish what winner gets – depends on suspicions of buyer: he could look at the distribution of c(1) – c(2) and reject if the gap is ‘too high’ – the cartel would have to trade off seller suspicion against cheaper cheating. –Divide the spoils: gain from collusion measured by gap between c(2) and arranged fee. Can divide equally, but may not reflect bidder asymmetry. Tacit collusion: can use early rounds to signal intentions then stop bidding, or signal via final digits.

4 EPUK Lecture 44 Many winners of procurement auctions If no prior investment (entry, R&D cost) and uncorrelated cost information, only use split awards when costs justify it –Decreasing returns to scale –Cost complementarities –Supply risk diversification Many auctions are not naturally one-dimensional (price quality, features, assurance, surge capacity, etc.) –Optimal mechanisms are very complex, hence not wholly credible –Can ask for variants, or offer a menu of contracts to bidders –Give contract to bidder with lowest “compliant” cost estimate or highest “power” incentive contract –This reduces information rent (not to 0), but does not reduce cost Split awards raise practical and conceptual issues Quite common in US; less common in UK, EC

5 EPUK Lecture 45 Practical issues If firms have decreasing returns to scale (no externalities) and similar (common) costs, splitting is best; if firms are asymmetric, targeting is better If firms have increasing returns to scale results are similar (trade off cost (and administrative) advantages of a pooled award against risk of higher cost, hold-up) – probably there is less than optimal splitting, esp. in UK where scales are low. There may be outside-market firm interactions (impact on competition of giving one firm a big public contract). This can be helped by a ‘menu auction’ –Each firm bids a positive or negative amount for each possible allocation (including allocation to other firms) –Buyer selects allocation with lowest total cost, pays according to second-lowest. These procedures fix how the market might be split and let the buyer decide whether to split.

6 EPUK Lecture 46 Multiple-unit auctions Discriminatory auction – each unit at price bid (or next higher price) Uniform price (gas, electricity) auctions like 2PSB, but more so – rife with collusion –Smart buyer might put in own bid, leaving cartel getting a low price for residual contracts –Smart buyer might use a bit of demand uncertainty –Some non-competitive bidders might inject supply uncertainty –Seller might choose ‘discriminatory’ auction where bidder gets price s/he bids for each unit –still scope for collusion if costs are non-linear in number of units

7 EPUK Lecture 47 Multi-unit auctions 1: bundling (Value V) Separate preferred by industry if A > 7; never preferred by buyer; preferred by society if A > 8 Cost (A) Cost (B) Cost (A+B) Bidder 1 4 5 9 Bidder 2 5 4 9 Bidder 3 10 A Form Win A Win B Profit Fee Welfare Separate Bidder 1 Bidder 2 2 10 V-8 Joint Bidder 3 9-A 9 V-A

8 EPUK Lecture 48 Multi-unit auctions 2: complementarity Sellers with unknown costs bid for contracts to produce complementary or substitute objects Standard package bidding solution (Vickery): –Sellers bid for all possible contracts –Buyer picks best way of dividing work-load –Buy each part from lowest bidder at highest price they could have bid while still winning that part This ensures that truthful bidding is dominant Works well if objects are substitutes

9 EPUK Lecture 49 Multi-unit auctions 3: Vickery auction problems Standard solution may not pay off: B supplies 1, C supplies 2; each gets 3 If B, C merge (decreasing joint cost to 1), they’d get 1: net payoff falls to 0, deterring efficient merger. n Standard solution may allow cheating: If A faces an honest B, he’ll get both contracts and fee of 2. If B masquerades as B1 and B2, each ‘subsidiary’ wins the service contract he bids for and is paid 3. n Other problems: budget sets may destroy dominance, lead to different agencies paying different amounts for same services. May have no equilibrium. Also very complex. There is a ‘proxy bidding’ solution SupplierService 1Service 2Both services A331 B133 C313 SupplierService 1Service 2Both services A331 B222 B1133 B2313

10 EPUK Lecture 410 Beyond the tender: supply relationships Often have to procure complex systems, including complements (in demand) These need not come from the same supplier – if not, relationships (e.g. supply chain management, interoperability, whole-system reliability) become important. Strategic problems: –A boycotts or nobbles a competitor B (cost-imposing strategies, lobbying) –A does not cooperate fully with ‘partner’ B (esp. in sharing information or R&D results). This may be particularly important when they operate on wider markets –A and B may use the supply relationship to facilitate collusion –There are theoretical incentive schemes that can prevent excess returns Client-supplier cooperation: may need to share experience with supplier and avoid later hold-up –Government-owned, contractor-operated facilities –PFI (contractor-owned, government-operated), etc.

11 EPUK Lecture 411 Supply of competing goods Reducing information disadvantages –In selection (affiliated-costs example, linkage principle) –In contract operation (benchmarking, yardstick competition) –Contracting as a form of observation A flexible solution: balancing competition within the contract with competition for the contract: multiple-sourcing –Use ‘design competition’ to select 2 (say) suppliers with (slightly) differentiated competencies –Split award along component lines in (say) 70%:30% chunks) –Require information-sharing and common specifications –At the end of each ‘period’ give 70% share to contractor who did best on that component End of contract: –Incumbent advantage –Intellectual (and other intangible) property created as a by-product of the contract

12 EPUK Lecture 412 Breach and renegotiation Any contract has conditions under which it has not been fulfilled Sometimes this is efficient (as when the original aim is unfeasible Contracts may specify penalty clauses –liquidated damages (money) –specific performance –Surety agencies Courts must enforce and interpret. Long-term contracts are particularly subject to ‘changes’ Can renegotiation serve a strategic role?

13 EPUK Lecture 413 Renegotiation, 2 Often, more than one party has to make relation-specific investment between signature and fulfilment (e.g. R&D, hiring workers, training,…) This can lead to underinvestment An enforceable contract cannot specify efficient levels of investment, since it binds the parties separately – not jointly If one party cuts back on investment needed for the contract as a whole –They get the entire cost savings (as a benefit to shirking) –They share the reduced ‘gains from trade’ This can be fixed by precommitment to specific types of renegotiation By analogy with the above section on multiple-unit auctions, problems associated with direct externalities may be harder –Suppose better system design can reduce training costs or vice versa –Then optimal results only available under ‘flat’ objectives –Particularly relevant to PFI/PPP and product innovation

14 EPUK Lecture 414 Now back to reality… Public procurement is big business: –For the OECD, total procurement as a proportion of GDP is estimated at 19.96% ($4,733 billion – 1988 data) –For non-OECD countries, the figures are 14.48% or $816 billion) –For the EU, 2004-5 data show € 1500 billion contract volume (16% GDP including public services/utilities); more than 6M contracts let by 400K contracting agencies –Of this, a smaller fraction is potentially contestable by international trade: 7.57% ($1,795 billion) for OECD, 5.10% ($287 billion) for non- OECD –Different ‘level’ (1997 data) Central government: 29% (incl. non-competitive defence procurement) – ranging from a low of 28% of sub-central expenditure (De) to 3 times as much in the UK Public utilities: 24% Sub-central government: 47% (mostly contestable) – different degrees of control, aggregation possibilities, emphasis on ‘embedding’ benefits and mix of goods and services.

15 EPUK Lecture 415 More background to rules and practice… Government procurement traditionally tends to favour local suppliers, with effects similar to other protectionist measures (limited choice, increased prices, reduced efficiency) Attempts were made to bring government procurement under multilateral trade rules since World War II. First real progress: 1981Tokyo Round Agreement on Government Procurement Next step: 1996 Government Procurement Agreement (WTO) Regional counterparts for NAFTA and EC Basic rules: transparency and non-discrimination

16 EPUK Lecture 416 Discrimination Three main forms –“Overt exclusion”- foreign bidders are excluded from tendering (esp. defence contracts) –“Preferential price margin” - purchasing entities accept domestic bids unless price difference exceeds a specific margin –“domestic content requirement” - government only purchases from foreign sources if they agree to buy some components from domestic firms A fourth, “hidden” form is non-transparent tendering procedures that favour ‘insiders’ Early work (Baldwin and others 1970-1984) found no adverse impact: increase in domestic government demand offset by increase in private demand for foreign goods Work in late 1970’s compared public and private purchases and found substantial (up to 6X) potential welfare gains from procurement reform Francois (1996) analysis for US found a small impact overall, but large in key sectors e.g. construction, maintenance and repair services General consensus: benefits from shifting profits to domestic firms offset by increasing procurement costs All these empirical studies struggle with complex bidding behaviour, imperfect competition and informational asymmetries

17 EPUK Lecture 417 EU legislation First directive on public procurement adopted in 1971 1990s: Need to review public procurement Directives – 3 different directives (goods, services and utilities). Two new directives adopted on 31 March 2004 after four years of intensive work (co-decision procedure) –2004/17/EC for Utilities –2004/18/EC for “Classic” (Public) Sector Modernisation (new purchasing methods) Simplification (fewer directives, articles, simplified “roadmap”) Intent is to enhance flexibility and lower compliance costs while ensuring basic principles of equal treatment and transparency and enhancing competition –e-procurement –competitive dialogue –performance specifications, etc.

18 EPUK Lecture 418 The new EC Directives Two Directives (Classical and Services) Specific quantitative thresholds Like all EC Directives, need to be taken up in national legislation Directives establish a choice of procedures Restricted procedures are based on a shortlist of invited parties Strict rules on tender specification, sharing of clarifying information, selection criteria, ‘debriefing’ etc.

19 EPUK Lecture 419 MEAT: most economically advantageous tender Not clear that it is always best to choose the lowest- price bid. –Hidden tradeoffs (features, quality, time, certainty, etc.) –Non-monotone marginal expenditure curves –Pressure of ‘customer 2’ (user) –Securing ‘genuine’ competition and encouraging entry –Externalities (e.g. interoperability) What defines ‘economic advantage’? –Value for money –Different implications at specification and selection stages

20 EPUK Lecture 420 More meat… Public contract award governed by Article 53 of Directive 2004/18/EC, which outlines two criteria: –Lowest price only; OR –Most Economically Advantageous Tender (MEAT) Procurement best practice indicates best value not usually achieved by lowest cost award. Article 53 does not define MEAT - it gives example criteria –Price –Quality –Technical merit –Aesthetic and functional characteristics –Environmental characteristics –Running costs –Cost-effectiveness –After-sales service –Technical assistance –Delivery date –Delivery period –Period of completion Often, other criteria (working/partner relationship, innovation, risk management, etc.) added UK defines value-for-money as “the optimum combination of whole life costs and quality to meet the user requirement”

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