Comparable Economic Model of Traditional Public Procurement

increasing the benefits B. This is so because it captures only a fraction r of the effort it gives to improving the service, but all the yields from cost saving efforts e_c go to the project company – the government “profit” is independent of the costs, π_g = (1 – r)B(e_b). The concession therefore ensures efficiency, but unless the revenue mechanism is tied to the costs as well, it favors the project company in the long-run, and equitability of the contract is not ensured.

Within the limits of this model we can also infer that the private company assumes all production risks related to general macroeconomic conditions and input and prices unique to the particular infrastructure asset. Or more accurately, the financiers of the private company assume the risk θ, which is reasonable, given that they are also entitled to all the surplus yields from cost savings.

4.3 Comparable Economic Model of Traditional Public Procurement

this contractual model, it is necessary to employ a stylized model, which (hopefully) captures the essential features of the traditional alternative.

To develop a good comparable reference to PPP, we will again assume the same hypothetical highway infrastructure project as in the development of the PPP model. However, in the traditional approach no separate project company is established; the government finances the infrastructure investment by borrowing on its general credit rating; and contracts with construction companies and operators through fragmented, short-term, lump-sum competitive bidding, when it does not rely on its own producer units. The long-run management and integration of multiple works contracts remains with the public sector; works are exhaustively specified, and the public sector carries out design prior to procurement. Finally, private contractors are responsible for the deliverables only within standard warranty periods. The figure below (Figure 20) schematically summarizes the main participants and key terms in the traditional model of infrastructure production.

Government

Society Infrastructure Asset

Debt Markets θ

D

B

C

t

I r_f

Operation Construction

Figure 20 A model of the key parties and flows of funds in traditional procurement

The most important issues to notice are that the infrastructure asset is represented as inseparable from the government, who finances and holds ownership to the asset, and that both construction and operation are fragmented. The long-term risks θ related to the asset are internalized and hidden in the government entity. The construction of the infrastructure

asset again ties up capital equal to I, the cost of construction, which is raised from in the form of debt D from financial institutions in debt markets at the risk-free rate of interest.

Furthermore, having the asset in operation delivers annual aggregate benefits of B to the society, but incurs a constant annual private cost of C to the government, which goes to sub-contractors. The government raises various taxes t, e.g. vehicle and gasoline taxes, which it channels through its budget to cover its operating costs defined by C, and to service its debt capital liabilities. The boxes representing construction and operation are split into sections to emphasize the idea, that the traditional procurement is typically concerned with more narrow works and services packages in both physical and temporal scope. The procurement and production of an infrastructure asset equivalent to a PPP project is thus achieved by a composite of multiple smaller projects in both physical and temporal scope.

4.3.2 Contractual Relationship in Traditional Public Procurement

Let us next briefly explore the consequences of the contractual relationship in traditional procurement practices more formally by applying the principal-agent framework. Let us denote the total social revenue of an infrastructure project by π, the contractor’s efforts by e, the contractor’s compensation by w, and include a random variable θ, which captures the risks of the project. It is important to note that the risks imply the potential for an upside as well as a downside. For example, the material or labor costs may turn out to be lower or higher than initially expected.

Suppose next that the government enacts a typical competitive tendering process, through which it awards the project to the contractor that offers to deliver the project at the lowest constant wage w. In the principal-agent terminology, a lump-sum contract is a variant of the a fixed fee contract, where the wage w to the contractor is independent of π, or e, and the contractor takes on the risks θ, so that the government receives π_g = f(e) – w. The cost-plus contract is equivalent to a hire contract, where the contractor receives remuneration based on some observable output

measure e and a unit wage w, so that the government receives π_g = f(e) – we.

Let us further assume that the total profit is positively dependent on some level of effort e that is costly to the contractor, who can also choose between two levels of effort, high e* and low e. Suppose that e* represents effort that conforms to the specifications of the government, and e represents deviation from the specifications. Suppose also that e* costs more than e to the contractor by a factor of c > 1, so that e* = ce.¹²⁶ Moreover, the government typically employs hostages, i.e. negative incentives, which take the form of a direct monetary post m, which the contractor loses in addition to the contract if its efforts deviate from what is agreed.

Let us assume the project is ultimately completed by the contractor. The contractors profit π_p, when it conforms to the contract specifications in a fixed fee contract is therefore π_p = w – ce + θ, and when it shirks, and does not to deliver what is specified, but is not caught, its profit is defined by π_p = w – e + θ; if caught, it loses the hostage m, and its profit is defined by π_p = w – e + θ – m. Similarly, in a hire contract, the contractor’s profit π_p, when it conforms to the specifications is therefore π_p

= we – ce + θ, and when it fails to provide what it is paid to provide, its profit is defined by π_p = w – e + θ or π_p = w – e + θ – m, depending whether the government catches the contractor shirking.

The important idea to realize is that, in essence, both contract types require that the contractor’s effort e is specifiable, observable and verifiable by the government. Under these conditions, the government can choose the desirable level of effort e* and impose it on the contractor, with the threat of the large punishment m if the contractor shirks. These are valid practices, and ensure efficiency when the trade involves a specifiable

126 A higher effort requires higher mental effort and or more sweat to ensure on-schedule delivery, high quality, and so forth.

object of delivery, and the principal can at a low cost observe and verify whether the contractor conforms to the specifications.

However, the problem in the construction industry seems to be that it is typically very difficult for the government to judge the quality of the contractor’s efforts, even when short-term fragmented works and services contracts are used. Whether or not the contractor’s efforts conform to the specifications of the government can typically be determined only after a significant time, typically outside of the warranty period. In other words, even though the contractor risks being punished, the probability p of being caught shirking, i.e. choosing e, is so low that it can be very appealing to avoid the costs c, which accompany exerting the high effort e*, i.e. ec >

pm.

It is empirically well documented that construction projects in practice involve recurrent negotiation to accommodate e.g. variation orders, the client is intimately involved in supervising the progress of the project, projects often lead to costly disputes, and quality problems are frequent. In reality the efforts of contractors in infrastructure projects are therefore perhaps not as easily specifiable, observable or verifiable as presumed.

Because the contractor has no incentive to protect the vested interests of the government, it is actually very likely that fixed-fee and hire compensation mechanisms do not result in efficient contractual relationships.

The equitability of the contract can also be considered as low, because the government typically captures a majority of the surplus the project implies by engaging in competitive bidding. A contract that is highly unfair to the contractor may also in practice be related to the efficiency of the project: A contractor may feel uncommitted to an inequitable contract, which, as a consequence may turn out indurable, leading to costly disputes, i.e.

inefficiency.

4.4 Description of Traditional and PPP Infrastructure Production