Competitive Tendering and Contracting Out: An Introduction.

Stephen P. King Economics Program RSSS Australian National University Canberra ACT 0200 August 3, 2001

Microeconomic reform has revolutionised the way people view government services throughout the world. The aspect of this reform which has captured the highest profile has been the privatisation of government business enterprises in areas such as telecommunications, energy production and distribution, transportation, and finance. Despite their importance, however, such asset sales merely represent the tip of the microeconomic reform iceberg. Much of the activity in reforming the public sector has involved reorienting the way in which governments provide goods and services. At the heart of this reform has been the movement away from unquestioned “in house” provision of many services to a reliance on competitive tendering and contracting to outside providers. While this reform may involve such mundane matters as who collects your household refuse, it has economic implications 1

which make questions about the ownership of Qantas or the Commonwealth Bank pale in comparison. Competitive tendering and contracting out (CTC) involves an explicit attempt to bring the pressures of the market place to bear on the provision of government services. To the degree that competition tends to drive producers to adopt innovative, cost-efficient methods of production and to respond quickly to the changing desires of their customers, CTC tries to harness these benefits in areas of the economy where competition and the market have traditionally been absent. The potential benefits from contracting out include lower costs, improved service delivery and quality, and greater flexibility. Where savings are realised and returned to citizens through lower taxes, CTC has the potential to lower the burden of government costs without diminishing service provision. If savings are used to provide more and better services, then CTC offers a way to raise the quality of social services at no additional cost. In technical terms, moving to CTC appears to offer a potential Pareto improvement–a way to make some people better off without harming anyone else. In lay terms, CTC offers a “free lunch”. Few economists, however, would accept the case for CTC without reservation. While the contracting out of government services may offer substantial savings, it also presents numerous traps for the unwary. The use of market provision does not guarantee competition and reduced costs. If the tendering process is ill designed then the outcome may be confusion and uncertainty.1
For example, the simple lack of a deposit requirement in the tendering process for satellite Pay TV licences in 1993 led to unexpected and undesired outcomes. See Pearce 1993.


If the contract that is implemented is itself poorly designed then it is unlikely that any of the parties to the agreement will be satisfied. If CTC leads the government to lock itself into agreements where it is at the mercy of an opportunistic outside party then purported cost savings may disappear as renegotiation takes over. While in theory it may be possible to avoid losers, in reality CTC will often leave some parties worse off. The simple picture of CTC presented above hides numerous controversies. This policy forum presents four papers which analyse the implications of competitive tendering and contracting out. Together they provide both a comprehensive overview of the issues surrounding CTC in Australia, and a guide to the potential benefits and pitfalls of such reform. In the first paper, Stephen Rimmer presents evidence on the growth of CTC. Local government in particular has a long history of using competitive tendering and contracting, but this use has increased substantially since the 1960s. Rimmer also refers to a number of studies which attempt to measure the potential cost savings of CTC. He notes that the evidence on cost savings at the local council level in Australia is unclear, but that evidence from both overseas studies and Australian studies at the state level have suggested savings of the order of 20 to 25%. These estimates are echoed in the second paper by Simon Domberger, who also notes the high variance of cost savings in some areas. Rimmer notes that, even when CTC leads to short run cost reductions, the extent to which these savings continue in the longer run is unclear. In part, this may be due to convergence between outside contractors and in-


house providers in different jurisdictions. Thus, there may be a spillover effect where improvements in efficiency brought about by competitive tendering in one jurisdiction are incorporated into in-house provision in other jurisdictions over time. This phenomenon has been observed in the contracting out of prison services in the USA (see Donahue 1989) and, as Rimmer points out, may account for the perceived lack of long run savings from CTC noted by some studies. It is commonly claimed by opponents of CTC that any observed cost savings merely reflect a decline in quality. The evidence for this, however, is far from conclusive. Rimmer notes that much of the existing evidence is ambiguous or contradictory, while Domberger refers to two recent state-level studies which do not show any evidence of CTC leading to a fall in quality. Even if the opponents of CTC were correct, and contracting out did tend to lead to lower quality services, this is not, in itself, an argument against CTC. A decline in quality accompanied by a fall in price may be socially desirable. Preferences for quality differ and it is erroneous to argue that a higher quality is always preferred if it involves a greater expense. If CTC did lead to a fall in quality this would only be undesirable to the degree that any concomitant cost savings are less than the willingness-to-pay for quality of the service recipients. To borrow Rimmer’s example, if in house production has led governments to provide “Rolls Royce” services when their constituents would really prefer “Hyundai” value then a fall in quality due to CTC can represent a social gain. Jeff Borland also considers the issue of quality in the third paper. Borland


makes two percipient comments. First, when considering quality provision under outside contracting, we need to compare the incentives for quality under such a contract to the incentives that face public employees under in-house provision. In neither system is it possible to simply specify the desired quality exogenously and expect it to be delivered. Quality is multidimensional and usually difficult or impossible to measure. Often quality (and even quantity) must be judged by second- or third-best measures such as the inputs used. It is far from obvious that the incentives for quality which face an outside contractor will always or even generally dominate those faced by public employees. Second, Borland notes that if the contracting process is led by financial considerations then it is likely that contracts will be awarded principally on the basis of price. In such a situation contracting may often lead to an undesirable erosion of quality. This possibility is particularly alarming given that the current increase in CTC has been directly associated with the fiscal pressures facing governments at all levels. When appraising CTC we need also to consider the incentives for politicians and whether they have the correct inducements to implement well designed, welfare enhancing contracts.2 Domberger also comments on the incentive problems that face both public officials and contractors under CTC. As Domberger notes, these incentives may lead to illegal bid rigging, where tenderers collude on the prices they offer to the government authority. While collusion is not only a problem of
In extreme cases in the USA, the incentives for politicians in the contracting process have been so poor that the system has become enveloped in corruption with campaign contributors being awarded contracts without any formal tender process. See Van Horn 1990.


government tenders, it may be exacerbated by the regular, repeated nature of the contracting process, which makes it easier for private contractors to “take-turns” winning bids. Collusion may also be aided by the tender process itself. For example, it is easier for potential colluders to detect “cheating” under an open format of tender or when the amount of the winning bid is publicly announced. If collusion exists, it may reduce or eliminate any gain to the government from the contracting process. For example, a study of bidrigging in the provision of seafood to the Defense Personnel Support Center in Philadelphia, found a mark up due to collusion of between 20 and 30%.3 As Rimmer and Borland both note, even when explicit collusion is absent, any gains due to CTC will be muted if the market for the provision of the relevant service is itself characterised by a lack of competition. While competition may be enhanced through the careful use of well designed tender procedures4 if there are few potential bidders then even the best designed tender may lead to higher, not lower, costs for the government. The degree of potential competition will vary widely between different services. Borland proposes that, as a rule-of-thumb, the savings to the government will be inversely related to the level of specific human capital required to provide the relevant service. In the extreme, when dealing with highly specialised services that require specific skills, contracting may just change in-house provision to outside supply without altering the identity of the providers. Contracting merely changes individuals from employees to contractors, and in so doing
See Froeb, et. al., 1993. See McAfee and McMillan (1988) for a description of these procedures together with empirical simulations for contracting in Toronto.
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may raise their bargaining power and their remuneration. If contracting out does lead to cost savings to the government, where do these savings come from? John Quiggin, in the final paper in this forum addresses this question. Quiggin argues that the majority of cost savings that have been identified in the literature have come from two sources. First, contracting has often led either to explicit or implicit reductions in the wages that are paid to the relevant employees. Thus, much of the purported savings due to increased labour productivity do not indicate improved technical efficiency but simply that the employees are working at a greater intensity.5 Second, direct savings to the government through CTC may reflect an indirect loss due to tax evasion. To the degree that private contractors can more readily evade taxes than public sector employees, contracting out may merely move funds from one part of government to another. If some of the savings from CTC simply reflect reduced real wages and tax evasion, this may mute but not eliminate the arguments in favour of CTC. In both cases, it may be argued, the source of cost reduction is simply a transfer so that it is irrelevant. However, as long as some real savings may be gained from CTC, the process should still be pursued. Quiggin answers this claim by noting that, in neither case, is the fictitious cost saving simply a transfer. Tax evasion leads to an explicit cost both by the public in engaging in evasive activities, and by the public sector in attempting to detect and limit such evasion. Similarly, if increased work intensity leads to a reduction
Savings may also reflect a shift from measured to unmeasured labour input. For example, if a contract refuse collection service uses less labour but requires more effort by the householder then any observed increased labour productivity may simply reflect that the householder’s effort is not measured.


in safety procedures or an increased risk of work related injury, then there is a real loss through contracting out. Further, if the government has monopsony power, which is offset by organised labour for public sector employees but may be exploited in a contracting process, then any reduction in real wages may push them below their socially optimal level resulting in a dead weight loss to society. What conclusions can be drawn from this policy forum? While the authors differ markedly in their support for CTC, they all note that the area must be approached with cautious intelligence. To rush helter skelter into universal or even majority contracting out at any level of government may lead to higher costs. The decision to introduce competitive tendering for a government service is not an obvious win-win situation but must be considered on a case-by-case basis. While significant savings may be reaped (at least by the government) by sensible application of CTC, it does not offer a panacea to public sector fiscal constraints. In fact to view it as such a panacea may undermine the effectiveness of CTC in areas where it does offer real benefits. References: Donahue J. (1989) The Privatization Decision: public ends, private means, Basic Books, Froeb L., Koyak R. and Werden G. (1993) “What is the effect of bid-rigging on prices”, Economic Analysis Group Discussion Paper 93-2, U.S. Department of Justice, Antitrust Division. 8

McAfee P. and McMillan J. (1988) Incentives in government contracting, University of Toronto Press, Toronto. Pearce D. (1993) Independent inquiry into the circumstances surrounding the non-requirement of a deposit for satellite pay-TV licences, and related matters, Department of transport and communications. Van Horn C. (1990) “The myths and realities of privatization”, in Gormley W.T. (ed), Privatization and its alternatives, University of Wisconsin Press, Madison.


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