Chapter 71 Procurement Contracting

Abstract

Purchases by government agencies from private sector firms are often initiated by solicitation of bids to supply the desired items. Payment to the firm that is awarded the supply contract may be determined by (a) the bid price or (b) bid price plus a share of the difference between observable production cost and the bid price or (c) observable production cost plus an additional fee that may be a function of costs. Interest in the theory and behavior of procurement contracting stems mainly from two features of the political economy: (a) government may have multiple, possibility-conflicting objectives in procurement; and (b) there may be an asymmetry in knowledge of some components of firms' production costs. One objective that government is likely to have in procurement contracting is minimization of the budgetary cost of making the purchases. Another objective that the government may have in conducting its economic activities, including procurement, may be the promotion of allocative efficiency. As we shall see, budgetary cost minimization and economic efficiency maximization can be conflicting objectives when there is a cost information asymmetry.