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FinanzArchiv / Public Finance Analysis
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FinanzArchiv vol.58 no. 2 103
1. Introduction
This paper deals with the purchase of a public project. The parliament spon-
sors a procurement agency which, in turn, pays a private seller who provides
his services. As in Niskanen's (1971, 1975) model1, the parliament is willing
to appropriate money for the completion of the project up to its evaluation
of the social benefit of the project. The agency is a budget-maximizing bu-
reaucrat2. It wants to maximize its power, which can be achieved best if it
spends as many dollars as possible. The private seller is a profit maximizer.
* This paper was finished while I was visiting EPRU, University of Copenhagen. The hos-
pitality of EPRU is gratefully acknowledged. The paper benefitted from comments by
an anonymous referee of this journal and by T. Ihori, Tokyo, C. Keuschnigg, St. Gallen,
K. Leipold, Washington, D.C., C. Liilfesmann, Bonn, S0ren B. Nielsen, Copenhagen, and
Peter Birch S0rensen, Copenhagen.
1 For a simple explanation of Niskanen's model see Mueller (1989, pp. 250-254).
2 The assumption of a budget-maximizing procurement agency is in contrast to several
other incomplete-contract models on public procurement, for instance Bos and Liilfes-
mann (1996) and Bos (2000), which assume a welfare-maximizing procurement agency.
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104 Dieter Bos
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Bureaucrats and Public Procurement 105
If only one seller provides his services to the agency, it seems natural that
only one contract is written which refers to both relationship-specific invest-
ments and the production of the project. However, in our model, agency
and seller should write two contracts. Their contractual relationship begins
with a contract referring to the specific investments of the seller. Then the
parties wait until the draw of nature determines the parliament's willing-
ness to pay for the project (project budget). On the basis of this budget the
parties write a second contract which refers to the production of the pro-
ject. The separation into an investment contract and a project contract is
rooted in the budget-maximizing attitude of the bureaucratic procurement
agency: it would be meaningless to stipulate a fixed project price before the
draw of nature determines the project budget, which is always fully exhaust-
ed by the agency5.
The setting of this paper is in contrast to the usual theory of incomplete
contracts, such as Hart and Moore (1988), Aghion et al. (1994), and Noldeke
and Schmidt (1995). In these papers the buyer and the seller write one and
only one contract at the beginning of their relationship, that is, before the
agents' uncertainty about benefit and costs is dissolved by a draw of nature.
Typically, in this ex-ante contract two prices are stipulated: a price p1 to be
paid if the project is completed, and a default price p0 if this is not the case.
After nature has revealed the actual realizations of benefit and costs, the
prices px or pQ may be renegotiated. In contrast, in our paper the two
prices are contracted upon at different stages of the game. p0 is stipulated
in a contract which is signed when the procurement agency starts with the
planning of the particular project; it is not a default price, but is paid or en-
cashed by the agency when the investment stage of the game ends./?! is stip-
ulated in a contract written after nature revealed the actual realizations of
benefit and costs. Since both contracts are written under certainty, neither
5 In the practical application the procurement agency should enter into a public-private
partnership, writing a long-term skeleton contract which states that the parties' total re-
lationship consists of two short-term contracts: if the investment contract is satisfactor-
ily executed, agency and contractor continue in their cooperation and write the project
contract.
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106 Dieter Bos
agency nor seller face any incentive to change any price at a later st
there is no renegotiation in our model.
The paper is organized as follows. Section 2 presents the sequencin
the game, the observability and verifiability assumptions, a detailed desc
tion of the interplay between the parliament and the procurement agenc
and, finally, the second-best benchmark which serves as the basis of
parison for the actually played game. Then, in section 3 we deal with
equilibrium analysis. We begin with the project game, where parliament
agency determine the price to be paid for the project, and the seller deci
whether to sign the project contract or not. Subsequently, we analyz
investment game, where agency and seller choose their relationship-speci
ic investments on the basis of an investment contract which, in turn, is b
on the parliament's investment budget. A brief summary concludes.
2. The model
If the public project is carried out, the parliament's benefit is B, and the pro-
duction costs are C. At the beginning of the game, the actual realizations of
benefit and costs are not yet known; they are determined by a draw of na-
ture at a later stage. This random draw selects the actual realizations of ben-
efit and costs from the following lists of deterministic variables:
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Bureaucrats and Public Procurement 107
ly. From the definitions of the probability distributions jv(a) and o(e), it fol-
lows directly that the first derivatives are constant and that they sum up to
zero:
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108 Dieter Bos
Table 1
Sequencing of Events
tractually promise to pay a price which may exceed its budgetary possibil-
ities at the moment when the project is finally carried out. Therefore, the
agency could only offer a price which equals the lowest budget which could
arise after the draw of nature. However, since the agency is a budget max-
imizer, no party would believe in this low price. Both agency and seller
would correctly anticipate that later on the agency will enforce a higher
price, thus exhausting the total budget appropriated by the parliament af-
ter the draw of nature7. Therefore, any ex-ante project price is meaningless.
Meaningful, however, is the ex-ante stipulation of a lump-sum payment p0
which is a compensation for the specific investments of the seller, or a pay-
ment for his participation in the procurement game. This explains the sep-
aration of investment contract and project contract. As already mentioned
in the introduction, there is no renegotiation in this model since both con-
tracts are written under certainty.
After motivating the separation of contracts, let us now consider the sev-
eral stages of the game (see table 1). At date 0 the investment game is
opened: the parliament appropriates the investment budget b > 0. A nega-
tive budget cannot be appropriated because of the procurement agency's
limited liability. The investment budget covers the costs of the agency's in-
vestments ji{a) and a lump-sum payment p0 to be encashed or paid by the
7 Any project budget which is set before the draw of nature would be adjusted by down-
ward or upward renegotiations after the draw of nature, because the parliament would
not be willing to pay more than its actual benefit from the project (downward renego-
tiation) and the agency, knowing the actual realization of the parliament's benefit will
always go for a budget which fully exploits the parliament's willingness to pay (upward
renegotiation). Anticipating this, the only meaningful procedure for the parliament is to
set the project budget after the draw of nature.
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Bureaucrats and Public Procurement 109
The supports of B and C, and the probabilities it (a) and o(e) are common
knowledge, that is, they are known to parliament, procurement agency, and
seller. The same holds for the investment-cost functions.
The actual realizations of benefit and costs, as determined by nature, are
observable as follows: The benefit B is known to the parliament and to the
procurement agency. It does not matter whether it is also known to the
seller. The costs C, however, in this model are assumed to be private knowl-
edge of the seller, that is, the producer is the only one who knows the pro-
duction costs. In Niskanen's original two-person model of a sponsor and a
bureaucrat, the bureaucrat produces the good and only he knows the costs.
We have extended Niskanen's model to a three-person setting, and it seems
natural to assume that, once again, only the producer knows the costs. Note,
however, that the results of the paper remain unchanged if we assume that
both seller and procurement agency know the costs (as long as the parlia-
9 Disputes on delivery and on payments would be decided upon after the end of a game,
either the investment game or the project game. However, in the subgame-perfect equi
librium no such disputes occur.
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110 Dieter Bos
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Bureaucrats and Public Procurement 111
If the project is completed, its costs C;- have been realized. Unfortunatel
when it has to appropriate the project budget at date 4, the parliament can-
not observe the actual cost realization which is private information of th
seller. Since payments are only the second-ranked part of the parliament
lexicographic preference ordering, however, it does not mind if it has to pay
more than the actual costs as long as the first-ranked objective of allocative
efficiency is not violated12. Therefore, the parliament is willing to spend up
to Btl{' + A) dollars if the project is carried out. This can be captured by the
following constraint:
/?•
project budget < -- l- . (7)
1+A
with respect to a and e13. Note, however, that the parliament has to con-
sider the agency's limited liability which requires b > 0.
12 Therefore, the parliament does not implement any direct mechanism in order to induce
the seller to reveal the actual cost realization.
13 The respective first-order conditions are necessary and sufficient for a unique and inter-
ior solution {a*,e*}>0. Formally, the existence of an interior solution is ensured since
expected welfare as defined in (8) is concave in the investments and the Inada condi-
tions with respect to fi(a) and ip(e) are assumed to be fulfilled. The maximum is unique
if one assumes | Wkk | > | (Wkm ',k,m e {a, e).
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112 Dieter Bos
2.5. A Benchmark
(fl*e*)eargmaxflte'W>= X; Xy Jti
£;>C,(1+A)
-(1 + A)b(a) + V(e)].
K = 0-B&Cj(l+k)
X;Xy ^g;(g)gg'"fi(a'+A)=^(fl)»
^i + A'
+ 02)
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Bureaucrats and Public Procurement 113
eral efficiency constraint ^>0 holds. Therefore, at date 0 the expected net
value of the project should be weakly positive, otherwise the project should
not be started at all.
3. Equilibrium Analysis
At date 5, the agency knows the project budget which allows for an expen-
diture of Pi dollars for the completed project. The agency is always interest-
ed in having the project carried out because otherwise its budget is reduced
to zero. Therefore, it wants to spend exactly pt dollars: the agency is not
interested in spending less, and it is unable to spend more. Therefore, at
date 5 the procurement agency has no freedom of decision and offers the
seller a procurement contract with price pt to be paid if the project is car-
ried out. Note that the agency cannot take the money ph pay part of it to
the seller and retain the rest for personal emoluments. The agency rather
has to forward all of the money to the seller, since payments are verifiable
and, accordingly, the agency could be sued if it used parts of the budget for
other purposes than for the particular public project.
Since the agency has no freedom of decision, at date 5 only the seller's
decision counts. He compares two situations: if the project is carried out, he
gets Pi and faces the production costs Cy. Otherwise, he has no production
costs, and does not get anything. Therefore, the seller will sign the project
contract if and only if15
Pi-Cj>0. (14)
Let us now step bac
This is the typical s
his model of bureau
learned the actual re
that the parliament
completion of the p
theagency makes a t
for the completed pr
the agency and the p
(£;/(l + A) if q =
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114 Dieter Bos
which is equivalent to
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Bureaucrats and Public Procurement 115
duction costs will 'throw away' this information because it could only lea
to a reduction of the project budget which is unwanted by the agency. (This
shows that all of our results hold as well if the agency knows the produc
tion costs, which proves our statement in subsection 2.3 above.)
The solution of this condition is the seller's investment function e(a) which
describes the adjustment to the agency's investment choice. We have de(a)l
da > 0: if the agency increases its investments, this implies an increase of the
left-hand side of (19), which induces a higher value of the right-hand side,
ip'(e), and, hence, a higher investment e. In other words, an increase in the
agency's investment increases the expected production rent of the seller
and, therefore, the seller has an incentive to invest more.
Note that the seller's marginal condition (19) is equivalent to the bench-
mark marginal condition (13). Therefore, the seller's investment choice will
lead to investment efficiency iff the procurement agency has chosen effi-
cient investments at date 1. Otherwise, if the agency has chosen positive but
inefficient investments, the seller will overinvest if the agency overinvested,
and underinvest if the agency underinvested (since de(a)/da>0). Unfortu-
nately, only by chance will the agency choose efficient investments, as we
shall see in the analysis of the agency's decision at date 1.
However, let us mention a particular exception. Assume that n(a)-ji for
all a. Then, the agency has no incentive to invest and a - 0. In this particu-
lar case of one-sided investments we attain investment efficiency, and since
project efficiency is always guaranteed, the (second-best) welfare optimum
is achieved.
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116 Dieter Bos
At date 1, the agency splits the parliament's investment budget into a bud
get for its own investments fi (a) and a lump sum p0 to be paid to, or
cashed from, the seller. We assume that the agency is in a stronger positio
than the seller. Therefore, the investment contract at date 1 is based
take-it-or-leave-it offer the agency makes to the seller. Since the agency i
a budget maximizer, it wants to maximize its utility consisting of the sum
its two budgets,
When maximizing this objective function with respect to a andpo> the agen-
cy has to consider the following two constraints. First, at date 1 the agency
knows that the parliament's investment budget amounts to zero (as we shall
prove when stepping back to the discussion of the parliament's decision at
date 0):
P0 + /x(«) = 0. (2D
Us>0. (22)
What are the res
ed in attaining t
er investments
project game an
ponents of the
tracts all of the
that is, by requi
ment game. Us=
A) = I/I; *i
Bt>c7(i+A) v1+A;
where the value of e(a) is given by equation (19). The payment of
is then used to finance the investment costs of the procurement ag
/*(*) = | A) | . <24>
Substituting (23) into (24), we obtain an e
fines the agency's investment choice.
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Bureaucrats and Public Procurement 117
Figure 1
Overinvestment by Procurement Agency
0 a* a°' a
18 Substitute Us, equation (18), into the welfare function <W, equation (8).
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118 Dieter Bos
a, hence it is a constant for this proof (this is particularly due to the speci-
fication of the probabilities JT/(«) whose derivative is a constant, see (5)).
Therefore, a constant is reduced by a function (1 + A) in'(a) which is mono-
tonically increasing in a. Since welfare maximization implies a unique inter-
ior solution <2* >0 with d(W/da = 0, the first derivative dW/da must be posi-
tive for a<a* and negative for a>a*. The proof of the concavity of <W is
completed by considering the second derivative
b = - <W(a*) (28)
is chosen as investment b
at figure 1. There is a uni
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Bureaucrats and Public Procurement 119
4. Summary
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120 Dieter Bos
ment agency can fully extract the ex-ante rent of the seller by stipulatin
negative lump sum to be paid by the seller for the right to participate in
procurement game.
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Dieter Bos
University of Bonn
Department of Economics
Adenauerallee 24-42
D-53113 Bonn
Germany
dieter.boes@uni-bonn.de
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