6.3 Contracting and procurement by the state

When non-contractible quality dimensions (or tasks) are important, letting suppliers or agents compete on price or other contractible dimensions may lead to a very inefficient outcome for the buyer/principal. Transactions, however, are often regularly repeated. Reputational forces may then help, and non-contractible dimensions can be governed by self-enforcing relational contracts. A supplier who overstates the quality of a good in circumstances where the quality of the good only becomes apparent after a period of use, a consultant or employee who purposely reduces non-verifiable but ex post observable effort below what was promised, or any other agent who behaves opportunistically can then be punished by the principal in future interactions. Cooperation incentives are typically stronger, the higher are future expected payoffs, and so relational-contracting needs may conflict with other important needs of a principal, in particular, that of inducing agents to compete, both to capture more surplus from the relationship and to screen and select more able agents. This means that, when designing a relational contract to govern non-contractible dimensions of the transaction, the principal must also take into account his/her present and future choices on whether, how and when to screen agents competitively, besides the design of any underlying explicit contract.

Private procurement and the importance of the interaction between relational contracts and competitive screening policies lie at the heart of many discussions about Toyota's “relational” procurement policies compared with, say, General Motors' more “competitive” or “arms length” ones. Toyota, along with many other Japanese firms, maintains a small stable set of “highly trusted” dedicated (and often exclusive) suppliers, restricts competition for the various orders to these suppliers, caring for their profitability and rewarding the best performing suppliers with a higher share of orders, while replacing those that fail to deliver the extremely high levels of contractible and non-contractible quality required. The limits to competitive screening have a cost in terms of reduced screening and therefore higher prices, but ensure sufficient weight is placed on the future and a consequent cooperative perspective in the supply relationship. This explains why Japanese firms were so unhappy when political pressure from the United States forced them to make their supply chain more open to competition from US suppliers. The general validity of this well-known story and of this interpretation of it in terms of interdependence between competitive screening and contracting choices has been empirically confirmed by a recent study showing that competitive screening and long-term relationships tend to be substitutes (see Radkevitch et al, 2008).

Turning to public procurement, Banfield (1975) draws attention to the reduction in the quality of government procurement linked to accountability rules forcing public buyers to use open auctions for supplier selection. Kelman (1990) followed up on the theme of quality losses linked to too rigid rules forcing open competitive screening of suppliers, and on the importance of taking past performance into proper account. He stressed the differences between public and private procurement processes, noting that private firms used open auctions much less often, left higher margins to suppliers, switched suppliers less often and were much more satisfied about the quality of the procured goods and service.

Calzolari and Spagnoloz (2009) developed and studied a dynamic model of recurrent exchange with non-contractible dimensions between an infinitely lived principal (the buyer) and a population of heterogeneous and privately informed, infinitely lived agents. The model incorporates both moral hazard (on non-contractible dimensions) and adverse selection (on agents’ type). Non-contractible quality can be governed by a relational contract, and should be interpreted in broad sense to capture all value-enhancing decisions, like investments, that a supplier is free to take during the contract execution and which the buyer observes, but cannot regulate with an explicit contract.[29]

Calzolari and Spagnoloz show that in a dynamic procurement process a buyer may optimally restrict the number of potential trading partners at the cost of reduced screening and more expensive procurement to boost non-contractible quality provision. By restricting competition, the buyer loses performance bonuses (since they are not more credible), but leaves firms sufficient future rents, so that they can find it profitable to build reputational commitments for future interactions and prefer to provide the high levels of highly valuable non-contractible quality the buyer requires (refrain from moral hazard). Shortening the duration of the (explicit part of the) contracts is crucial for the relationship. Abstracting from technological aspects such as the rate of obsolescence, a shorter duration of supply implies more frequent re-selection or search. Higher frequency of search makes it easier for a buyer to obtain high non-contractible quality levels from sellers by threatening to withhold the bonus or to exclude the seller from future trade. Indeed, with more frequent contracting, the threat of exclusion is closer in time and gains from "cheating" are smaller, so that higher quality can be expected.[30]

Thus, in this type of model, longer duration of supply contracts—less frequent auctions—together with larger pool of competing suppliers both deter collusion among eligible suppliers but also reduce non-contractible quality levels obtainable from them. Symmetrically, shorter contracts—more frequent auctions—and a smaller pool of suppliers both facilitate suppliers’ collusion but also the enforcement of non-contractible quality standards.