The procurement laws of all countries provide that with a few, narrowly drawn exceptions public contracts are to be awarded on the basis competition.  As the drafters of the UN model procurement law explain, the reason is straightforward. A competitive procurement gives all those seeking the government’s business an equal chance to win the contract while at the same time maximizing the chance that government will receive quality goods, services, or civil works at the lowest price.

The problem comes when would-be suppliers do not compete for government’s business.  When instead of each one preparing its bid independently, based on what price the firm can charge and still make a reasonable profit, the bidders sit together and agree which one will “win” the contract and at what price, a price that can sometimes be twice what it would have been were there competition.

How can a government reap the benefits of competition when bidders have rigged the bid? The answer is that it cannot.  At least not immediately.  It can, as both the U.S. Department of Justice and the OECD recommend, institute procedures that make it harder for firms to collude, and it can, again as both these agencies regularly urge, vigorously enforce laws that outlaw bid rigging.  But these measures take time to have an effect; in the meantime, a government cannot halt all procurements.  It still needs to buy computers, desks, and other goods, to contract with cleaning, fumigation, and other service providers, and it must continue to build and repair roads, damns, and other civil works.

So in the face of collusion or cartel-like behavior by its suppliers, is government powerless in the short-run?  Must it accept whatever price the bid riggers offer? No matter how high it might be?

One solution is to do what Japan, Taiwan, and the Philippines do: Set the maximum price it will pay for the good, service, or construction project it plans to procure and make it clear it will pay no more.  If this maximum, or ceiling, price, has been carefully calculated, it will protect the government from overpaying for what it needs while ensuring the firm that accepts the price earns a reasonable profit.

Setting a ceiling price is not a panacea, however.  While it is easy enough to determine one for goods and services readily available in the market place – office furniture, cleaning services, and such — it is much more difficult for more complex items built to order.  This is particularly true when calculating a ceiling for a construction project.  Estimating construction costs is expensive and time-consuming, and for a variety of technical reasons (unreliability of historical prices, fluctuations in labor markets, use of average rather than marginal costs), there is no guarantee it will be completely accurate.  An example from the U.S. state of Indiana.  Although state engineers followed elaborate procedures when estimating the cost of building new highways in 2010, their estimates averaged more than 25 percent over the winning bids.  Indiana was enjoying a construction boom while neighboring states were still in recession; as a result, contractors these states, desperate for work to stay in business, bid prices at or near their costs.

With Indiana the explanation for a high ceiling price is benign.  In other cases it may not be so.   Engineers may be bribed to pad their estimates to ensure the firm winning the bid earns supra-normal returns.

To protect against unlawfully inflated estimates, one safeguard is, as in Japan, to have an independent entity review the ceiling price and how it was calculated.  Another is to require the ceiling prices for public works contracts to be stated in the form of a ceiling for each item in the bill of quantity.  The bill of quantity for a project shows what the contractor will charge for the labor and materials required for the project.  If the foundation for, say, a bridge requires ten tons of concrete of a certain quality and 1,000 hours of labor, the BOQ will list the price per ton the contractors will charge for the concrete and the hourly rate for laborers. While there will be no market price for the bridge itself, there may well be a readily ascertainable market price for the concrete and the labor needed to build it.  (The cost estimating manual developed by the U.S. state of Minnesota details this and other ways to develop reliable estimates of the cost of large construction projects.)

Besides the risk that the ceiling price will be inflated, a second risk is that they will foster collusion in markets where firms find it difficult to collude.  Any group intent on rigging the bids on a project faces the challenge of agreeing on a “rigged” or “collusive” price.  A publicly announced ceiling price can be a great help, for it can serve as a reference or target price.  The companies agree on whose turn it is to win the contract and the designated winner either bids the ceiling or just below it with the other colluders submitting phony, “cover bids” to make it appear as though they are competing with one another.  Ceiling prices have been used as reference prices for Japanese firms colluding on public works tenders, and a preliminary analysis of the Philippine bid ceiling law found indications bidders there were also using the ceiling price as a reference point.

The risk that the ceiling price will facilitate collusion can be reduced by requiring that the ceiling price be kept secret.  In Japan the Ministry of Internal Affairs and Communications and the Ministry of Land, Infrastructure, Tourism asked local governments in March 2008 to stop publishing the estimated prices.  But keeping the price from being leaked is a challenge.  In Japan retirees of the Ministry of Construction are often hired by the construction firms because they can use their relationships with former co-workers to learn the ceiling price.  A second problem every country faces is that those who know the ceiling price will be tempted to leak it – for a price.

There is always the chance that the bidders will refuse to agree to the ceiling price, either submitting no bids or bids that all exceed the ceiling.  Philippine and Japanese laws both provide that if no bid meets the ceiling price, the tender will be reissued.  If, after this second round of bidding, no company has submitted a price equal to or less than the maximum, the procuring agency negotiates a contract.  Japanese law requires negotiations begin with the firm that submitted the lowest bid.  By contrast, section 53 of the Philippine statute permits the procuring authority to negotiate with any “technically, legally and financially capable supplier, contractor or consultant.”

The Philippine solution is preferable.  Recent work in auction theory suggests that when a purchaser confronts a tight-knit cartel opening negotiations with member selected randomly can undermine the cartel’s cohesion and possibly lead to its dissolution.

In the ideal world, all markets would be competitive, so that when a government needed to buy furniture or retain consultants or construct a road, many firms would compete for its business, and their rivalry is the best guarantee citizens have that government will get value for their money.  But as the founder of modern economic long ago observed, “People of the same trade seldom meet together … but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”  Vigorous enforcement of competition laws can put an end to conspiracies in public procurement markets, but until it does setting and then standing firm on a reasonable ceiling price remains governments’ second best option for frustrating bid rigging.