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World Trade Organization - page 28 / 35





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for a fixed price contract, and rent extraction which calls for a cost plus contract.31  

The GPA does not limit governments' freedom to devise procurement contracts provided they are not offered in a discriminatory manner.  Thus, as long as both domestic and foreign firms are offered the same (menu of) contracts, the GPA non-discriminatory provisions would not be violated.  However, a crucial problem arises in fixed price contracts when the fixed price at which the contract was awarded cannot be credibly enforced.  When a firm has ex post cost overruns, it can threaten to go bankrupt unless the government renegotiates the price upward.  The government is then confronted with the choice of either reimbursing the additional costs or switching to other sources.  If switching costs are significant, then the government may choose the former option.  

The anticipation of ex post cost reimbursement may clearly influence firms' bidding behaviour (and their ex post incentives to reduce costs).  Thus if all firms had an equal probability of bail-outs by the government, then all would choose to underbid.  But the government has significant discretion in whether it chooses to bail-out or to sue for non-fulfilment of the contract.  If it chooses to exercise this discretion in favour of domestic firms, i.e. domestic firms are more likely to be bailed out while foreign firms are more likely to be sued, then it will bias ex ante bidding behaviour in favour of domestic firms.  The latter will be able to systematically outbid foreign firms.  While the foreign firm would be bidding for a fixed price contract with a built in premium against the risk of unanticipated cost-rises, the domestic firm would be bidding for an implicit cost-reimbursement contract and would need to include no risk premium.32

Now, whether or not a firm is bailed out may seem a domestic contract issue.  But it is not more so than the primary act of procurement because the latter takes place in anticipation of the former.  This reveals a gap in the GPA disciplines:  while the challenge provision has made the initial procurement decision subject to challenge and review, there is no provision for the ex post bail out.  Given the likelihood of cost overruns in procurement contracts, this

    (As Laffont and Tirole (1993) show, it is actually optimal for the regulator to offer a menu of incentive contracts.  The reasoning is that the contract should be tailored to the firm's information.  The regulator discriminates among or screens the different potential types of the firm in the same way a monopolist price discriminates among consumers with different valuations for quantity or quality.

    (Laffont and Tirole (1993) offer several explanations for cost overruns, including the possibility that the government keeps adding design changes, but do not address the possibility raised here of implicit collusion between the procurer and the firm.


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