Saturday, 2 April 2016

The Ratchet Effect in Construction

An Economic Perspective on Construction Procurement 

The incentive problem in short-term contracting is the main issue addressed here. This problem in construction has often been seen from the perspective of the principal-agent problem, where the focus is on motivating the agent and monitoring outcomes. By taking the incentive problem as the focus of the discussion the emphasis shifts away from the relationship between the principal and the agent, which is well understood, to the effort a contractor will make to minimise costs or improve performance. This aspect of principal-agent relations has been a major theme in labour economics, the economics of regulation and elsewhere.

The process of procurement has a number of side effects. While the intention is to purchase, the method determines outcomes. For building and construction projects the method generally used is a form of auction, typically a common-values low bid auction, where bidder costs are the same or similar and the project is awarded to the lowest bidder. This process has all the characteristics of economic models of one period contracts in short-term contracting under information asymmetry. It is also the case that the major public and private sector clients are repeat clients as they regularly bring projects to the market, and this is equivalent to the two periods in models of regulation

Here some of the insights into the behaviour of suppliers or contractors from the economics of regulation is applied to construction contracting. The approach is interesting because it is now generally accepted that procurement can be treated as a subset of regulation, following the model developed by Laffont and Tirole, which treats regulation as a principal-agent problem, with the government as regulator the principal, and the regulated firm (in fact its manager) as the agent. The regulator can observe realized production costs, but not how much effort the firm puts into cost-reduction (a post-contractual hidden effort problem). Importantly, the firm knows more about cost-reducing technology than the regulator (a pre-contractual hidden information problem).

In their model there are two types of firms: low effort firms will not try very hard to reduce their production costs, while high effort firms will be very responsive to cost reduction incentives. Therefore the problem is modeled as one of information asymmetry, with the focus on discovering the manager’s type, whether they are a high-effort Type 1 or a low-effort Type 2.

The first type responds to contractual incentives while the second does not, so the principal can use incentives to induce more information revelation from the agent, i.e. to get the agent to disclose whether they are a Type 1 or Type 2 manager, and the regulator can make transfers to the firm. Such transfers are clearly necessary in the case of procurement, where the principal/client pays the firm/contractor for work performed under a contract to supply goods and/or services.

In this context what is called the commitment problem arises, because the optimum outcome possible in the first period, or round of tenders, cannot be repeated twice. The problem turns on the existence of asymmetric information. In each of the two periods the government/regulator wants to procure a public good, and if they could credibly commit to a long-run (two-period) contract the optimal two period outcome would be the same as the one-period optimum twice. They call this the perfect commitment outcome. The perfect commitment outcome requires credible commitment to a long-run contract.

If the regulator cannot make credible long-run commitments, long-run contracts are ruled out. With the regulator unable to write a long-run contract with the regulated firm, it has instead to govern the relationship by a sequence of short-run (one-period) contracts.

This gives rise to what is known as the ratchet effect, an outcome of the regulated firm’s unwillingness to reveal whether it is a Type 1 or Type 2 firm in the first period, because that would mean the regulator no longer faces asymmetric information, and allow the regulator to take any gains by the firm from, for example, cost reductions that might be the result of the firm’s efforts or use of new technology.

Laffont and Tirole proved that after period 1 the regulator will in general not know the firm’s true type. Intuitively, the ratchet effect implies that information unfolds slowly, as the manager tries to protect his information rents by not revealing his true type. Thus the ratchet effect happens when an agent works hard and shows a good result, but the principal then may demand an even better result in the future. Anticipating this, the rational agent has little incentive to work hard in the first place, and this tendency for performance standards to increase after a period of good performance is called the ratchet effect.

Early formal models of ratchet effects emerged in the 1980s, and ratchet effects were predicted in specific informational and contractual environments where hidden action and hidden information must be present, and the parties must be in a repeated relationship yielding some quasi-rents to both where binding multi-period agreements are not feasible.

How does this apply to building and construction?

Is it likely that construction contractors respond to clients’ requests for bids by attempting to preserve hidden information? Is it possible they will not want to reveal themselves as a Type 1 cost-minimising firm? There seems to be three reasons.

Firstly, it reduces competition to a straightforward shootout on price, but because all tenderers have similar costs this is just a decision on margin, based on current and expected workload. Therefore the competition in any given tender is likely to be driven as much by contractors’ workload considerations as their estimated cost of the project. Even without cartel arrangements this is a form of managed competition, whereby the tenderers will not deviate too far from the client’s expected cost for the project, which will also be similar to industry estimates, thus avoiding revelation of a significant cost advantage on one project that might jeopardise margins on future projects.

Secondly, it allows for gradual improvements in productivity and efficiency, which are neither disruptive nor expensive to contractors, but will deliver a windfall gain to the contractor if a project comes in well under budget or schedule, which may be the result of some innovation by the contractor. This gain will, of course, be hidden from the client and from competitors as much as possible.

This suggests that there might be many cost reducing innovations available to contractors at any time, but the pressure to apply them will be muted by market conditions and a contractor’s appreciation of competitors’ likelihood of using them. Innovation is used here as a broad term that covers any and all product and process developments that can reduce final construction costs. There are costs and risks associated with innovation, so it is in the interests of all bidders to minimise these costs to themselves.

Thirdly, the winning bidder will always have the option of revealing themselves to be a Type 1 firm, if for some reason they want to. There will usually be some innovation available that will reduce project costs, but will be costly (i.e. require upfront investment) to the contractor. Thus the success of many major contractors in winning repeat work through negotiation rather than tendering is explained. By pushing the innovation boundary to reduce costs on the period 1 project the contractor gets the period two project without tendering costs at the new level of the client’s price expectation. (This does not exclude more traditional methods of cost reduction such as cash farming or subcontractor oppression of course).

The general argument made here is that the ratchet effect in the procurement process used in building and construction (typically auctions of single projects) will limit cost reductions from productivity and efficiency gains by contractors and subcontractors. This is an outcome of the unwillingness of bidders to reveal their hidden knowledge to clients, who will then expect future performance at the improved level. This is because clients typically only offer a single project at a time, or sometimes a bundle of projects, instead of sequences of projects. Thus short term contracting under information asymmetry.