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In a world of perfect information, since all buyers and sellers know what price currently prevails in the market, any effort by a seller to secure more than the market price will fail; any effort to get less then market price will similarly fail.
Stephen Bauld
Stephen Bauld

Procurement Perspectives | Stephen Bauld

In a world of perfect information, since all buyers and sellers know what price currently prevails in the market, any effort by a seller to secure more than the market price will fail; any effort to get less then market price will similarly fail.

The characteristics of the goods and services selected by the individual economic actors are perfectly understood in a similar manner by all actors.

The reality, of course, is that there is no world of perfect information, nor is there any world in which information is costless. What markets must therefore do is adjust contracting practice so that contracting decisions can focus on some specific criteria that are universally understood and readily comparable.

Price is that criteria. Put another way, suppliers, (who for the most part will draft the contracts) cut back on the risk that they are prepared to assume, so that they can offer the most attractive cash price to prospective buyers.

Hence, as a general rule even in markets where there is only a limited degree of concentration, over time the contractual terms offer to customers by suppliers both trend towards favoring supplier interests over those of customers, and trend towards uniformity from one supplier to another.

Government contracting departs from this norm, but the factors that influence government suppliers are nevertheless similar. Although the world of municipal contracting might seem at first blush to stand a very good distance from the world of price theory, in fact price theory plays itself out every day in the world of municipal contracting in ways that are both predictable and almost uniform in consequence.

The relative size of government allows them a degree of market influence.

Thus, governments have a limited ability to dictate contract terms to the market — provided it is understood that in doing so, the effect will be to adjust the cash price that must be paid under the contract. More generally, the consequences of departing from prevailing market practice and terms is that any such departure will be reflected in a higher contract price.

The prevailing market price for goods and services will reflect the normal allocation of risk between supplier and customer, the normal customer’s service needs and delivery expectations.

It seems fairly obvious that when a customer insists upon delivery to some remote location, then the price charged by the supplier to that customer must necessarily increase by a corresponding amount, to reflect the higher costs incurred by a supplier in dealing with the customer.

Similarly, any adjustment of risk that departs from the allocation of risk prevailing within a market will also result in a corresponding similar increase in price. So long as the adjustment to price properly reflects the probability adjusted cost implications of the occurrence of a particular risk, such variation neither improves nor worsens the city’s position. The city will pay a higher price for the supply that it receives, but its overall cost (i.e., full-life cost) remains the same because the selling price increase will be balanced by the increase in the supplier’s anticipated cost in meeting the risk assigned to it by the municipality’s form of contract.

Problems arise, however, when a city seeks to push the envelope too far. In many cases, the allocation may generate a disproportionate cost increase relative to the benefit that it affords.

For this reason, a number of terms of this sort have appeared in recent municipal contracts across Ontario actually work against the municipality’s own interest. Contract terms add “dead weight” to a contractor’s final price, whenever the cost of meeting those terms exceeds the benefit by shifting risk to the contractor.

Moving forward, municipalities need to work on developing standard contracts that are fair for both the municipality and the contractors.

Stephen Bauld is Canada's leading expert on government procurement. He can be reached at stephenbauld@bell.blackberry.net.

by Journal Of Commerce

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