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The Governance of Contractual Relations: Incentives and Transaction Costs. Steve Tadelis UC Berkeley Prepared for ESNIE Cargese, France May 2008. The Role of Contracts. The “broad” economic problems: choice and decision-making in a world with scarcity
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The Governance of Contractual Relations:Incentives and Transaction Costs Steve Tadelis UC Berkeley Prepared for ESNIE Cargese, France May 2008
The Role of Contracts • The “broad” economic problems: • choice and decision-making in a world with scarcity • production, distribution, and consumption of goods and services • The Role of Contracts • Facilitate the production/delivery of goods and services • E.g., sales, rentals, licensing… • Activity of Focus: Procurement • Delivery of goods and services between parties in the “shadow” of an existing institutional backdrop
Procurement Contracts • The economic problem of procurement: • Identify the need and understand the deliverable • Find capable sellers and anticipate their costs • Make sure that sellers deliver on promise • In practice, procurement is either: • Off the shelf, well specified products/services (boring!) • Custom design, uniquely built products/services • Problems with custom design • Design and specs may be (and are often) incomplete • Design problems/evolving needs require adaptation • “Adaptation costs” may be severe
The Questions: • What contacting structures are most efficient? • Uncover the costs/benefits of different contract regimes • Identify empirically measurable attributes for policy • How should contracts be awarded? • Award mechanisms are tied to contract regimes • What are the economic costs of adaptation? • Measure the impact of change on costs above and beyond the efficient cost of “change” • What are the resulting policy implications? • Common concerns of private information may be less important than mitigating adaptation costs
The Approach • Ingredients: • In the spirit of Williamson (TCE): adaptation cost focus (simple, right, plausible, testable) • Agency rigor (incentives and contracting costs) • Focus on empirically measurable trade-offs • Tradeoff:productive efficiency vs. explicit contracting costs. • Fresh interpretation: “make” or “buy” cast in terms of input versus output contracting.
Theory: A simple model • Based on Bajari and Tadelis (2001) and Levin and Tadelis (2008) • Technology: • One unit of service to be procured • quality depends on labor inputs: q = (+e)t. • t¸0is time on the job, >0 is baseline productivity and e¸0 is “effort” intensity. • Endowments: • Agent is endowed with time T to be allocated between time on the job and some outside activity that pays w> 0 (outside job or value of leisure)
Model, cont. • Preferences: • Agent (seller): Likes money, not work (needs incentives) • Principal (buyer): Likes “performance” and money • Contracting: • Principal can contract on performance or time • Costs of writing/enforcing contracts: • On time: small (some > 0) • On performance: costly • Contracting costs increase in “complexity” • Complexity is hard to pin down (costly to describe, monitor, measure; need for flexibility…)
A Helpful Conclusion Proposition: The optimal contract either contracts only on time or only on performance, but not on both
Results and Comparative Statics V(q,s) W (q |EC) Production costs with employment contracts specifying “time” costs W (q |PC) + k(q,m) adding performance contracting costs W (q |PC) Production costs with Performance contracts specifying quality
Introducing Adaptation and Decisions • Technology: • Ex post noise ε calls for making decisions to best adapt the production to achieve quality q: q = (+e)f(d,ε)t. • f(d,ε) a productivity coefficient. For any realization of ε there is a unique maximizer d. • Preferences: • Agent’s preferences are given by • Notice the potential conflict over decisions.
Contracting Assumptions • Principal can contract on three dimensions: • Minimal performance standards: • Minimal time on job: • Decision rights: which party chooses d • Costs of writing/enforcing contractssame as before (cost of contracting over who makes decisions is trivial) • Note: Assumptions on contracting and information are symmetric vis-à-vis ex ante and ex post. (q and d)
Results: General idea PRT (Hart) Labor (time) • The technology of a transaction: Labor (“effort”) Function q Material and Machines “Decisions” • Question: Optimal contract/Governance? • Buy: Buy performance/function • Make: Buy inputs and control decisions • Similar complementarties and comparative statics
Implications for Public Procurement Basic comparative statics predictions. 1. Higher costs of specifying, measuring, or adjusting desired performance less performance contracting (more C+ and more “make”). Scale economies: city size and location. 2. Small/rural cities are more constrained (less economies of scale and less markets) modeled trade-offs most relevant for larger cities. 3. Small cities may use public contracts as imperfect substitute for inhouse. Political economy effects. 4. Cities with more politically motivated decisions -- mayor rather than manager, older cities with established unions less contracting. 6. These cities should also place less emphasis on economic trade-offs model trade-offs less relevant. Contracting scope economies. 7. City managers must learn to write/manage contracts, so contracting may be more likely in cities that provide a lot of services • These predictions are tested and verified in Levin and Tadelis (2007) (Survey was key!).
Award Mechanism Policies • When transactions are simple, FP contracts should be selected and awarded by auction • When transactions are complex, C+ contracts should be selected and negotiated with reputable sellers • Another reason to negotiate complex projects is to extract information ex ante from the selected seller • These predictions are verified in the private sector (Bajari, McMillan and Tadelis, 2008) but not in the public sector. Why? • FARs prohibit negotiated contracts • What are the implied adaptation costs?
Trying to Measure Adaptation Costs • Do anticipated changes affect seller bids? • Need to Incorporate changes into a bidding model • Back out the effect of expected changes on bids • What are the economic costs of adaptation? • Need to know contract’s initial condition • Need to know what the changes were • Need to measure the impact of change on the project’s costs above and beyond the efficient cost of change • What are the resulting policy implications? • Need to try and stack up the adaptation costs against fear from corruption • BHT (2007) address the first two questions
Unit Price Auctions: A Hybrid Contract • Highway construction: • Gravel, asphalt, sidewalk, measured in some units • A specification of a project can be in how much of each input (output) is needed • (Timber selling auctions: Haile; Athey-Levin) • flexibility built into the contract: • Task is known but quantities are not • If there are changes to the quantities ex post (incomplete design) then the payment mechanism for changes is clear.
Unit Price Auctions: Example • A specification is a vector of quantities for the measurable units expected to be used • A bid is a vector of unit prices per quantities • A price is the dot product of these two vectors • Winning bid is evaluated by price (usually lowest)
Adjustments, Extras and Deductions • Adjustments • Engineer’s estimated quantities may be off • actual quantities differ from estimatedones. • Large deviations: adjustments to final payment • Our data includes estimated quantities, actual quantities and adjustments to payments • Extra Work • Unanticipated problems in the design • Our data includes payments for extra work • Deductions • Contractor screw ups (time, specs, etc.) • Our data includes deductions
Adaptation Costs • τ = proportional adaptation costs so total adaptation costs are: K = τA+A+ - τA-A- + τXX - τDD • With adaptation costs, R(bi) = ∑Tt=1btiqta+ A + X + D – K • If changes and adaptation costs are anticipated, we can use bids to back out the implied adaptation costs! • BHT (2007) do exactly this: adaptation costs are very large!
Concluding Remarks • Simple model of procurement Contracts • View as choice of contractual form (employment/C+ vs. specific performance/FP). • When “output” contracting is too expensive then replace it with a partial control of inputs and decisions • Trade-off: productive efficiency vs. contracting costs. • Designed with empirical predictions in mind • Consistent with previous empirical studies • Useful to guide public (and private) sector • Offers some “Williamsonian” guidance into the choice of procurement regimes as they relate to transaction characteristics. • Lesson is that adaptation costs can be severe, so contractual choice should be mindful of these.
