The Quality of Contract Execution Depends on the Process of Contract Selection

Last week I complained about the dearth of practical, policy-relevant literature available to help governments oversee contracts for the construction of civil works, the development of complex software programs, and other products which take months if not years to complete.  This is but one of many examples where governments must navigate the procurement process without rigorous, empirically grounded work on what procedures to employ when and how.  Absent such guidance, the procurement community falls back on rules of thumbs, old saws, and folk wisdom — the accuracy of which is always suspect.

One of the more suspicious sounding old saws in the procurement practice is the notion that contract execution and contract selection are independent activities — the belief, in other words, is that that how one selects a contractor is of little or no import for how well the contract is performed. But economic theory and recent empirical work both cast doubt on the accuracy of this bit of folk wisdom.

First of all, while belief that the contract selection process doesn’t affect how well the contract is performed might be true if performance monitoring were perfect, in practice monitoring is never perfect — both because hiring an army of monitors would be prohibitively expensive (and impractical), and because the monitors themselves might be corrupted (as I discussed in my last post).  For that reason, the quality of contract performance is likely to depend not only on the terms of the contract, but also on the incentives of the contractor.

And that leads to the second point: when contractors are selected through a corrupted process, these contractors might not have the right incentives to do the job well.  Consider, for example, bid rigging cartels, which the OECD reports are common in the construction industry.  When such cartels operate, a government tender for a highway, bridge, or dam does not lead to vigorous competition among firms for the job.  Rather, the colluders have already agreed who will win what job at what price.  Why would a firm that knows it has a guaranteed share of the business work hard to meet the contract terms?  What incentive does it have to perform? Indeed, the incentives are just the opposite – to lay back and do as little as possible.

Some recent empirical work substantiates the notion that when collusion or bribery impedes true competition in the contract selection process, contract performance also suffers.  In an August 2013 paper,  Lewis-Faupel, Neggers, Olken, and Pande report the effect of using e-procurement to award public works contracts in India and Indonesia.  In both countries its introduction stimulated more competition for the projects, and greater competition in turn improved contract performance.  In India the quality of the roads built after e-procurement was introduced was higher, in Indonesia more projects were completed on time post e-procurement.

Decarolis offers even stronger evidence that the method of contract selection cannot be divorced from that of contract monitoring.  Using Italian data on the introduction of competitive bidding for public works at different times in two provinces, he shows that where monitoring institutions are weak, the benefit in terms of lower price from the introduction of competition is lost thanks to a large deterioration in contract performance. (Parenthetically, these results, as he notes, calls into question the procurement policy reforms the World Bank and other donor agencies have urged developing countries to embrace.)

Two papers alone may not slay the claim that the quality of contract execution is independent of the process of contract selection.  But perhaps now the burden of proof should lie with those who believe they can assure the performance of a contract irrespective of how the contractor was selected.

6 thoughts on “The Quality of Contract Execution Depends on the Process of Contract Selection

  1. Your point is obvious.
    I know a business man who bid on a tender for a specific thing. He lost the tender to one of the other bidders. He was called to a meeting with the winner and the tenderer. There was an attempt to persuade him to accept a sub-contractor role to fulfil the requirements of the tender. The winner had no capacity to fulfil the tender. The business man refused on the grounds that the winner of the tender would never pay him.

  2. There is an additional, obvious reason for why contract selection and contract performance are almost always linked. If a a company needs to pay a bribe in order to win a contract, the money used for the bribe comes from somewhere. Most of the time, a company that won a contract through bribes subtracts the bribe from the money received under the contract, thus leaving less money available for execution of the project. This is one of the main reasons that corruption in procurement in development projects results in a lower level of execution: roads too narrow for trucks to use it; inoperable irrigation canals; hospitals with leaking roofs and unfinished windows.

    • Colette, your comment reflects one strand of the lore about the impact of bribery. While it is certainly logical, how often it holds empirically is a matter for research.

      Here is another possibility: Suppose that in an unconstrained market a contractor can execute the contract for 100 where execution includes a return on capital that reflects risk, current interest rates, etc. Now suppose the contractor pays a bribe of 30 in return for which it is awarded the contract at a price of 150. The contractor would still have sufficient funds to complete the project.

      My conjecture is that the alternative scenario I sketch out is at least as common as the one you posit and possibly more so. After all, the median overcharge in cartel cases is 25%* and statements elicited from those who colluded on some World Bank projects claim to have inflated the unconstrained price by 100%.

      If I had to guess, I would guess that the “not enough money thanks to the bribe payment” school of thought reflects the learning in auction theory on the “winner’s curse.” Where all bidders use the same metric to value the item to be auctioned, the winner, in an unconstrained market, will overbid. Note of course the qualifier — an unconstrained market.

      ………………………………………
      *John M. Connor, Price-Fixing Overcharges, 2nd ed., West Lafayette, Indiana: Purdue University, 2009.

  3. Of course, the quality of contract execution depends on the process of contract selection. But this is the case whether or not the selection process is corrupt. The biggest risk of corruption and poor performance in project execution is the acceptance of a bid from an inexperienced contractor at a price that is too low to cover the cost of construction – both of which are a common result of the World Bank policy of opening bidding to all and awarding contracts on the basis of price. While open competition can get a good price at contract start date, this is not the key to getting better ‘value-for-money’. It is the price at contract completion that matters – as well as the time taken to complete and the quality of the completed work.

    Why is it so hard for economists (with a few eminent exceptions) to understand what has been recognised by the construction management profession for decades? Why is the myth of competition as the way to address corruption in the procurement of works still so powerful? Corruption occurs at all stages of construction projects and each stage impacts on the next which implies that the most serious forms may be those occurring during project preparation. The corruption issue will only be seriously addressed when ‘procurement’ is understood as only one stage in Public Investment Management.

    • Jill, thanks very much for your comment. I quite agree that the question is not lowest bid price but best price (value) at contract completion. Indeed, not only do I agree with you but perhaps the low point in a not very stellar legal career was being on the wrong end of a jury verdict that arose from a client’s failure to appreciate the difference.

      The client, a construction management firm, received three bids for the electrical work on a $100 million plant modernization. Two were around $14 million and the third was for $7.5 million. The client accepted the $7.5 million offer without inquiring into how the firm could do the job for so much less than the others. It turned out it could not; a young estimator had made several rookies mistakes the produced the unreasonably low bid, and once the contractor began work it realized it had woefully underbid. Finishing the electrical work was on the critical path; the contractor tried to use this as leverage to renegotiate; bargaining reached an impasse; the lawsuits began to fly; and with the exception of the lawyers everyone was a loser.

      My client should have asked the low bidder for its drawings. Had it done so, it would have quickly caught the errors the inexperienced estimator made and either rejected the bid or asked that it be resubmitted. The client’s staff was negligent for not having done so.

      In my case the owner was a private company and the construction manager thus had a free hand in determining what bid to accept. The situation is much different when the owner is a government. The risk that corruption will infect the process results in all sorts of limitations on the owner or its agent’s discretion to reject a low bid. After all, it might be that there is nothing wrong with the low bid; but someone with connections to the government, or someone who has bribed the agent, is the next lowest bidder. Can’t risk that – no matter what. The root of the problem is, as Kelman put it, “fear of discretion,” that is, the fear of letting procurement professionals who work for government exercise any discretion at all.

      That fear now appears to have taken root among procurement professionals. A 2006 study of public procurement of civil works in the EU reported that, despite the provisions in the controlling EU directives that permitted the use of “best value” criteria in the selection of a contractor –

      “the practice of national public procurement authorities was strongly biased towards selection on the lowest price, rather than taking into account quality criteria. . . .This was not simply willfulness on the part of public procurement authorities, but had deep roots in the character of the European public sector, with its concern for accountability and inherent desire to have clearly defensible decisions.” Manchester Business School , Final Report: Analysis and assessment of the elements of certain Community policies that impact on the competitiveness of the construction sector, November 2006, http://ec.europa.eu/enterprise/sectors/construction/files/compet/analysis_assesm_policies/final_report_en.pdf

      Although I do not know of similar studies in the U.S., I have been told by students of the American federal procurement system that a similar, risk adverse behavior is the norm among federal procurement professionals. So simply changing the rules to grant procurement staff the discretion to choose on the basis of something other than lowest bid price may be of little help.

      I suspect it is less misguided economists than it is this fear of discretion that explains why the procurement rules of the World Bank and other public authorities so tightly constrain the selection process. Perhaps, if procurement staff were rated not on their ability to mechanically pick the lowest price but on whether the project came in on time and budget, things might change?

  4. You suggest that ‘simply changing the rules to grant procurement staff the discretion to choose on the basis of something other than lowest bid price may be of little help’ – because of the risk aversion of procurement officials who will always go for lowest price. That may be so but how about REQUIRING that procurement officials consider factors other than price? (Past record on completion on time, quality, practice re. claims, accidents – all of which can be objectively assessed) . Would the risk of corruption be any greater? It can be argued that it would be considerably less. if contractors and consultants were appointed on the basis of their past record or performance and – including their record on .

    My comment about economists and their obsession with competition relates to the belief that competition is the way to address corruption. As Gustavo Piga has shown, discretion is not eliminated by awarding contracts to the lowest price bidder. (Gustavo Piga – ‘a fighting chance against corruption in public procurement’ in Rose Ackerman and Tina Soreide (eds) International handbook on the economics of corruption volume 2).

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