Dec. 2008, Vol.4, No.12 (Serial No.

43) Journal of Modern Accounting and Auditing, ISSN1548-6583, USA

The analysis of government procurement

in the frame of principal agent theory∗

HE Zheng-qiang1,2
(1. Department of Accounting, Hunan College of Finance and Economics, Changsha 410205, China;
2. School of Accounting, Hunan University, Changsha 410079, China)

Abstract: In government procurement activities, asymmetric information, incomplete contracts and

opportunism, led to the dysfunction of principal-agent. Through the reference of the principal-agent theory, this
paper uses the model of the principal-agent to analyze government procurement activity, and proposes some
countermeasures to improve principal-agent in government procurement.
Key words: government procurement; principal-agent; supervision

1. The principal-agent relation in government procurement

The related parties in the government procurement mainly are: the taxpayer, the government, financial
department, state institutions and supplier. Under centralized purchasing operating mechanism, these parties have
formed a principal-agent chain in the process of government procurement management: (1) Taxpayer is the
supplier of government procurement fund, commits the public funds to the government through the legal process.
So the first agent relation of the taxpayer and government formed. (2) Since the public administrative field of the
government is very broad, it is impossible that government will do everything. Under the authority of the
functions, financial functions will be further delegated to the financial department. So the second agent relation of
government and financial department formed. (3) Financial departments work out law and regulation, supervise
the implementation, work out standard of supplier’s qualification and so on. It is impossible that financial
department takes on everything. So financial department sets up a special organization (purchasing center) in its
internal. Such the third agent relation of financial department and purchasing center formed. (4) The concrete
government procurement activity is expertised by official, such the fourth agent relation of purchasing center and
purchasing official has formed.
The agency chain like “the taxpayer-the government-the financial department-the special purchasing
organization-the purchasing official” is formed in the process of government procurement. The taxpayer is the
initial consignor, and the purchasing official is the ultimate agent. However, in fact the taxpayer who is the initial
consignor do not manage authority in the process, can not make purchasing decision and gain profit in the
progress. So the purchasing official who has professional knowledge is responsible for purchasing activity, and
plays the decisive role in the chain. But the purchasing official is a rational economic man, he runs after the
maximization of self-interest. It is difficult to execute government procurement law and realize the target of

∗
The paper is the achievement of the project (No. 06B016) supported by Scientific Research Fund of Hunan Provincial Education
Department and the project (No. 2007FJ3054) supported by Scientific Research Fund of Hunan Provincial Science Department.
HE Zheng-qiang, lecturer of Department of Accounting, Hunan College of Finance and Economics, Ph.D. of School of Accounting,
Hunan University; research fields: financial theory and practice.

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 The analysis of government procurement in the frame of principal agent theory

government procurement while conflicts are occurred between his benefit and the consignor’s benefit. The
principal-agency problem is happened in the agency chain because of the inconformity of interests between the
consignor and the agent.

2. The causes of principal-agent dysfunction

In fact, the principal-agent problem in the government procurement is dysfunction of principal-agency in

public right. It has three causes as follows:
2.1 Asymmetric information
In principal-agent operation of public right, who owns the most information, it owns the latent advantage
right. Because government procurement is highly professional, the agents such as purchasing officials, who
propose the scheme of government procurement, own more private information than the consignor in general. If
the consignor wants to gain the special information, he must cost more than the agent. Besides, it is difficult to
check the conspiracy between the agents, even if the consignor is not very difficult to observe, the cost is much
more. Therefore, decision-making of the consignor in the government procurement is under the control of the
agent who provides information. In fact, the range of government procurement, the way of government
procurement and the quota standard of government procurement are all decided by the agent ultimately. The
asymmetric information has provided possibility that the agent deflects the consignor’s target.
2.2 Incomplete contracts
The principal-agency relation is a kind of contract relation essentially, consignor and agent can standardize
both sides’ behavior by the way of signing a contract when they are practicing government procurement. The
principal-agency relation is a long-term contract. But the contract is incomplete, it can not anticipate all possible
scenarios, neither can it standardize the responsibility of each side under any circumstances. So official must give
sufficient liberty right for dealing with various kinds of unexpected things. As the asymmetric information of the
government, the finance branch, the special purchasing organization, the purchasing official, the supplier and the
agent can run after the maximization of self-interest through incomplete contracts, and then damage the taxpayer’s
interests.
2.3 Opportunism in the supervision of consignors
The consignor must operate the supervision to ensure procurement official to carry out purchasing right
according to the wish of the consignor. But the purchasing right already becomes the public product from private
product, and the consignor's supervision to the agent is inefficient. The causes are as follows: (1) The cost of
supervision is big. Since the purchasing right source is from the multilayer principal-agency, in responses with the
fact that the principal-agency chain enhances, the cost of supervision has enlarged. (2) Opportunism in the
supervision of consignors. Since the consignors of purchasing right are the extensive taxpayers, and the private
right of everyone in common field is limited, therefore every consignor is lack of enthusiasm. Firstly, the loss
which is brought about by the principal-agency problem in the government procurement is enormous to society,
but the cost sharing equally to every consignor is comparatively small. Secondly, single consignor’s supervision
needs to cost time and energy etc., the chance cost of this part is very big to himself, even if he supervises well,
urge the official executive purchasing right according to entire consignor wish, his interest because of the good
supervision is very minor. Therefore, consignor does not have the enthusiasm to supervise but hope others to
supervise, which leads to nobody's supervision. Finally, different consignors have different information, and it is

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 The analysis of government procurement in the frame of principal agent theory

very difficult to reach coincidence in the assignment of cooperation benefit. Therefore it is very difficult to adopt
selective incentive policy in supervision between extensive consignors.

3. The model of the principal-agent in government procurement

3.1 The behavior of agent

Assuming the regular income of purchasing official is S1 , the extra income coming from collusion with
supplier is E( t ) , the right of purchasing official is t , and assuming greater right to bring more extra income
coming from collusion ( E(t ) ≥ 0 ). The probability that the collusion being discovered is q , the subsequent
'

punishment is C1 . When official conspires with supplier, his expected revenue is:

(1 − q ) ⎡⎣ S1 + E(t ) ⎤⎦ − q ( S1 + C1 )
The regular income of official is S1 , the constraint condition making official not to conspire with supplier is:

S1 ≥ (1 − q ) ⎡⎣ S1 + E( t ) ⎤⎦ − q ( S1 + C1 )

1 − q C1
S1 ≥ E(t ) −
2q 2
3.2 The behavior of suppliers
Assuming the regular income of supplier is S 2 , he can earn profit Y if he conspires with the official, but the
cost that supplier pays to the official is E( t ) , the probability that the collusion being discovered is q , the
subsequent punishment is C2 . Assuming the probability that supplier’s and official’s collusion being discovered is
the same. They may not be equal certainly in reality, but the main body of the paper is qualitative analysis in
progress, even if concrete differentiation of q1 and q2 , it just change quantify result, it does not affect discussion
of the paper substantial. When supplier conspires with official, his expected revenue is:

(1 − q ) ⎡⎣ S2 + Y − E(t ) ⎤⎦ − q ( S2 + C2 + E(t ) )
The regular income of supplier is S 2 , the constraint condition making supplier not to conspire with official is:

(
S 2 ≥ (1 − q ) ⎡⎣ S 2 + Y − E( t ) ⎤⎦ − q S2 + C2 + E(t ) )
1 − q E( t ) C2
S2 ≥ Y − +
2q q 2
3.3 The behavior of consignor
The punishment of official and supplier in collusion is the avails of successful government supervision, as a
result, government’s supervision avails is composed of two parts, the part of official is C1 , the part of supplier is
C2 ; under the unsuccessful supervision, government's loss ought to be E( t ) and Y. Besides, the social costs

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 The analysis of government procurement in the frame of principal agent theory

consumed by supervision are K q . It is net loss in supervision. Evidently, the marginal cost of discovering
collusion increase with the increasing of q . Therefore, consignor’s avails are:

(
q ( C1 + C2 − K q ) − (1 − q ) E( t ) + Y − K q )
The constraint condition of government supervision is that the avails must be more than 0 , otherwise the
supervision is not worthwhile. The constraint condition of government supervision is:

( )
q ( C1 + C2 − K q ) − (1 − q ) E( t ) + Y − K q ≥ 0

Y + E( t ) + K q
q≥
C1 + C2 + E( t ) + Y

C1 + C2 − K q
q ≥ 1−
C1 + C2 + E( t ) + Y
Through above analysis , the government can constraint the official and supplier’s collusion in three ways: (1)
Raising the regular income of official ( S1 ), then supplier has to pay much more cost, if cost is more than avails,
collusion will be automatically eliminated; (2) Strengthening the intensity of punishment ( C ), then the risk and
chance cost of official and supplier’s collusion are increased; (3) Improving the probability that the collusion
being discovered ( q ) through the comprehensive supervision in government procurement, once the official
conspires with supplier, it will be treated immediately.
Rising S1 is the problem in the study field of stimulating mechanism theory. But government officials are
public servants, their high salary needs to accept the constraint of state budget, and can not exceed the capability
of country and taxpayer. Therefore, it is difficult to raise their regular income significantly; as a result, the effect
of rising S1 is limited.
Enhancing C and q is the problem in the study field of supervision mechanism theory, and it needs our
priority investigation and discussion. C and q are interrelated, and the strengthening of C is realized by the
improving of q .
Agent’s moral hazard originates from the asymmetric information between the consignor and the agent, if the
consignor does not supervise well, it will enlarge the asymmetry of information, then increase the risk of moral
hazard. Therefore, government must construct comprehensive supervision mechanism and improve the
effectiveness of supervision to reduce the degree of the agent deflecting the consignor’s target.

4. The countermeasures against principal-agent problem

According to the analysis of principal-agency model, we believe that problem can be resolved by the
following three countermeasures.
4.1 Executing the government procurement laws strictly
Firstly, the government must reinforce propaganda work of the government procurement law and relevant
regulations, improve publicity system and information disclosure system. Secondly, the government must improve
government procurement law further, enforce the law strictly. Thirdly, we must persist in the principle of open,

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 The analysis of government procurement in the frame of principal agent theory

fair and impartial, open the plan, procedures and appealing approach, make suppliers to compete sufficiently.
Finally, according to our national condition, the government should establish supervision laws and regulation as
soon as possible standardize the procurement budget, procurement plans and procurement process.
4.2 Building effective accountability mechanism
Firstly, the performance appraisal system must be established, the system can contact reward of government
procurement staff with the quality of implementation of procurement policy. The performance appraisal system
will be realized by signing contracts which can determine the object of procurement, the target of procurement
and appraisal methods of procurement staff etc.. Secondly, the appointment system must be established.
Incompetent staff can not continue to be employed. Outstanding procurement staff will be employed. Finally, the
intensity of punishment must be strengthened. The reason why the behavior of the agent is contrary to the will of
the client is that the agent can obtain additional benefits, but the clients do not know. Therefore, besides appraisal
system and appointment system, we also must raise rent-seeking legal costs and political costs of agent by
strengthening the intensity of administrative punishment and criminal penalties.
4.3 Building perfect supervision mechanism
Firstly, internal supervision mechanisms must be improved. Management departments must be separated to
operating departments thoroughly. And we should clear the right of procurement staff and the staff who
responsible for contract review and inspection. Secondly, relief mechanisms must be improved. We should
establish unobstructed complaints channel for suppliers. Third, diversified methods of supervision must be
established. Financial departments, discipline inspection departments, supervisory departments and auditing
departments participate in supervision together, and then a balanced mutual restraining mechanism formed.
Finally, effective social supervision mechanism must be established. The news media play the role of
dissemination; the rent-seeking behavior in government procurement must be made public. At the same time,
strengthening public’s awareness of public supervision, the public should report on the rent-seeking behavior. In
short, we should mobilize all supervision forces fully and implement comprehensive supervision. Only in this way
can we effectively prevent the rent-seeking behavior.

References:
[1] GUO Ping and HONG Yuan. (2004). Economic analysis of rent-seeking behavior in government procurement. Enterprise
Economy, (8).
[2] ZOU Jin-wen. (2002). Economics perspective of government procurement. Contemporary Financial, (2).
[3] Comfort, Iraq Congcong. (2004). Principal-agency theory and its application in the government procurement. Logistics
Technology, (3).
[4] ZHANG Wei-ying. (2000). Game theory and information economics. Shanghai: Shanghai Sanlian Press.
[5] CAN Yang-ming and LI jing-you. Government procurement research. Beijing: Economic Science Press, 2004.

(Edited by Canny and Cathy)

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