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Why Public Contracts Follow Different Rules than Private Contracts

Written by Featured Organization on 23 October 2009.

Have you ever wondered why government agencies engage in costly and inefficient public contracts? Political economist Pablo Spiller found that a fundamental difference between public and private contracting is the potential scrutiny of public contracts by opportunistic third parties. Understanding the risk associated with this scrutiny, according to Spiller’s latest research, is the first step toward improved regulation, efficiency, and reduced costs.

 

Spiller is the Jeffrey A. Jacobs Distinguished Professor of Business and Technology at the University of California, Berkeley's Haas School of Business. His research focuses on institutional analysis, regulatory issues, and the political economy. Spiller belongs to a group of Haas School faculty experts renowned for their research in organizational economics that includes Nobel Laureate Oliver Williamson, David Teece, Steven Tadelis, and Rui de Figueiredo.

Consider this basic example. The government plans to buy new computers. Despite a variety of choices in quality and price, the government selects a model that fits its specifications, but is not the best quality for the price. “It’s not because of collusion against the government, but because the government cannot easily enter into long-term, exclusive contracts that may be called favoritism,” explains Spiller.

The findings in Spiller’s paper, “An Institutional Theory of Public Contracts: Regulatory Implications,” incorporate the outcomes of more than 50 contractual conflicts between governments and contractors that occurred over the past 20 years. Many of the conflicts occurred when the government attempted to either adhere strictly to the terms of the contract in reaction to an unexpected event or unilaterally change the terms of the contract. Private party conflicts arising from similar unexpected events tend to be resolved through negotiation and adaptation within the existing contract. In such cases, Spiller notes, formal “re-contracting” is the exception more than the norm. Spiller differentiates between “third-party opportunism” and “government opportunism” as two basic kinds of conflicts that lock public agencies into rigid and potentially costly contracts.

Governmental opportunism involves unilateral changes in the rules of the contractual game when political or economic conditions change. An example is the privatization of public utilities in Argentina in the 1990s and their subsequent reversals. In 2002 the country faced a large-scale devaluation that would trigger automatic price increases of public utility services. In response, Argentina changed the implementation of the privatized utilities’ concession contracts, forcing many into default.

Third-party opportunism, on the other hand, involves interested third parties who may benefit politically from exposing a hint of corruption in a public agent’s actions. Spiller says it is often difficult to separate complex implementation from corrupt implementation, and that is when the potential for third party opportunism occurs. “Complex implementation is required in flexible contract adaptation between private contracting parties,” explains Spiller. “Corrupt implementation is when a public agent adapts a contract to benefit the contracting part. “

The possibility of third-party opportunism, in turn, creates incentives for public agents and their contractors to develop more specific and inflexible contracts in the first place. “These contracts are likely to demand more rigid procedural processes, including formal procedures for renegotiation,” says Spiller.

Third-party opportunism thrives, says Spiller, where some political contestability and fragmentation exists. Climates ripe with political instability breed governmental opportunism. “In the middle, between stable centralized party control and rampant instability, is where most of the world democracies fall.”

Spiller concludes the propensity for third-party opportunism limits attempts to compare the productivity and performance of public procurement contracts with contracts between private organizations. Instead, he says, governments seeking to improve their contractual relationships would benefit by studying comparable bureaucracies, such as neighboring states.

“Third-party supervision, however, is also fundamental in a democratic society,” writes Spiller, “Here in the United States, we can’t complain about seemingly inefficient public contracts. It’s the price of civil society.” Spiller, however, suggests remedies may be reached through regulation and reviewing the use of incentives.

Watch Prof. Spiller discuss his research on video: http://www2.haas.berkeley.edu/Videos/Research%20Videos.aspx

The full paper is available at http://www.nber.org/papers/w14152.

Haas Research Intelligence features the latest research news from Berkeley-Haas faculty: http://www2.haas.berkeley.edu/News/Research%20News.aspx

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