Thursday, November 29, 2007

The Economics Of Bid Pricing

I haven't participated in any mono-logical debates with letter writers recently, nor have I recently talked about economics. In fact, I haven't talked about much of anything recently. Well, of that is about to change.

In case you've forgotten, or are new to this blog, the deal is this:
-Original words appearing in letter to the editor: bold
-My excellent, omni-brilliant commentary: normal font. Because I'm a normal guy.

The "worth Repeating" feature quoted Mayor Ellon O. Moyer as saying that "No crystal ball revealed that our low bid minority contractor (for the expansion of the city police station) would deliver such an inferior product."

What is the deal with the middle initial always included with the mayor's name? We freekin' know who it many Mayor Ellen Moyers are there?

By the way, to know what this person is talking about, click here.

What about "low bid" does the mayor not understand? The architectural firm responsible for the fiasco at the Market House was probably the low bidder also.

Ha! Excellent. Not unlike myself, the letter writer has nothing to lose since his/her writing is not the source of any income nor subject to any professional obligation. Translation: bring on the baseless accusations!

I understand that government wants to get fair value for its money, but invariably the requirement that the low bid be taken means inferior design and workmanship. In many instances the decision-makers look only at the price and do not compare apples with apples, but apples with oranges.

Or coconuts!

Moving on, let's address the claim that taking the low bid invites inferior design and workmanship. The most basic of economic theory is predicated upon 'perfect competition' in the market. A perfectly competitive market is characterized by several things, notably:

-many competing firms
-homogeneous (the same) products/services
-no barriers to entry (meaning any new business can easily start up)

Given a market for contractors with these characteristics, you would always take the low bid. But very few markets are perfectly competitive*. And when you introduce elements of imperfect competition, complications arise and the decision of which bid to take becomes less clear.

(*Agriculture and gas stations are probably as close as you're going to get.)

The most common way that a market becomes imperfectly competitive is differentiated products. For example, you may think that fast food is a perfectly competitive market, but people do choose Wendy's over McDonald's because the spicy chicken sandwich is better. The point is, if you thought this way, you would not buy a chicken sandwich at McDonald's just because it's cheaper, as the only place you can get the product you want is at Wendy's.

Now consider contractors. Not all are the same--some have different expertise in different things. So right off the bat, you should be thinking about soliciting a contractor who can do what you want, not just the lowest price. And once you find the ones that can do what you want, you still have a problem: adverse selection.

Adverse selection roughly means the following problem: the people competing for your business are precisely NOT the people you want to be dealing with. For example: banks want to loan money to people with stable finances. But, people with stable finances don't need loans! So, if someone needs a loan, the bank knows that they are probably not so good at handling money, and will take great precaution to make sure they get paid back.

Again, consider contractors. You want to pay the lowest amount, but the contractors willing to work for the lowest amount are probably the ones with the least skills. After all, the labor market rewards value, and in the absence of a market distortion, a person who does a better job will be rewarded with the ability to command a higher salary.

Ok, enough already. Let's get to the point. Taking a low bid contract is appropriate only if you believe the low price is the result of a comparative advantage in productivity enjoyed by the low-bidding firm. In other words, if a company knows how to do something better, quicker, or using fewer people, they can make the same amount of profit while charging less money. This is when you take the low bid. If not, their bid is 'artificially' low; you are actually buying a differentiated product--and that difference is usually lower quality, or hidden costs elsewhere.

I believe that I was analyzing a letter........

So now, for the police station project, there is the cost of the lawsuit against the insurance firm, the already-lengthy delays in opening the station, and the need for additional remedial work. This could have been avoided.

The cost of the lawsuit is a perfect example of the hidden costs that I was just talking about, albeit an extreme example. The usable life of the work is another--which would you rather do: pay $5 million in 2007 for construction and another $5 million in 2010 when it breaks, or pay $7 million to have it done right the first time, and it lasts until 2020?**

(**Answer: $7 million once.)

I, too, am a minority contractor. My company has never once won a low bid contract. My company prides itself on supplying products and workmanship of the highest quality. This cannot be accomplished when you have to be the lowest bidder. You really do get what you pay for.
U.G. ALLISON, Severna Park

As the writer alludes to, the real question is why the bid is lower. Certainly some companies are smarter and more efficient, and their prices will be better for it. However, many companies try to offer a lower price at the beginning to gain the initial contract, figuring that when things go wrong, the customer will say "Geez, this company is already familiar with the project, let's just give them more money to finish the job."***

(***For more on this phenomenon, do a search on this blog for 'market house air conditioner'.)

Hopefully the new central services director can prevent this in the future.

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