Ippc2014presentation

<IPPC２０１４：Parallel Track 2>

THE EFFECTS OF FAVORITISM

ON TENDERING SYSTEMS IN

JAPANESE LOCAL

GOVERNMENTS

August 14, 2014

SATORU TANAKA (Kobe City University of Foreign Studies)

SHUYA HAYASHI (Nagoya University)

CONTENTS

1. Introduction -- Japanese Tendering System and Its Transition

2. Favoritism in Japanese Tendering System

3. An Empirical Study on the Effects of Favoritism on Tendering System adopted by Local Governments

4. Conclusion

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1.Introduction -- Japanese Tendering

System and Its Transition

Japanese tendering system which is legally based on the Japanese Accounting Law is classified into three types of competitive tendering.

1) normal competitive tendering

(first-price sealed-bid auction)

A contract for an offered object is awarded to

a winner of the auction who is determined by

free and fair competition among entitled

participants.

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2) scored auction

A winner is determined by the total score

which reflects both price and non-price

attributes (quality).

3) competitive tendering by public invitation

The government first determines participants

of an auction based on its relatively

discretionary procedure. After this process,

first-price sealed-bid auction is carried out

among the invited bidders.

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In Japan many bid-rigging cases have been repeatedly exposed since 1990.

(cf: Tanaka & Hayashi (2011))

Because the causes of bid-rigging is

considered to be the lack of competitive

environment and transparency of tendering

system, procurers are forced to adopt more

competitive and transparent system.

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This brings about a drastic change of

tendering type which public procurers mainly

adopt. Instead of the competitive tendering by

public invitation, they tend to use simple price

auction or scored auction.

The ratio of the number of the competitive

tendering by public invitation to total number of

auction for public work: 68.86% (2007) → 45.46% (2012)

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The nature of competition and transparency in each tendering system supports the recent trend of drastic change of tendering type.

---- The procedure of determining the participants of an

auction in the competitive tendering by public invitation

heavily depends on discretion of public procurers.

---- This auction style often restricts competition among

the participants. Table 1

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Mean std. dev. N t-value

Tendering System

price auction with public

invitation 90.59 4.34 195

simple price auction 87.64 4.52 195 13.67***

price auction with public

invitation 90.54 4.34 194

scored auction 87.54 4.40 194 13.06***

<Table 1> average number of the winning bid to reserve price in

the three tendering system

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１．Introduction

-- The purpose of this presentation

In spite of the overall trend, when we focus on local governments (prefectures) as public procurers, it is observed that their choice of main tendering style extremely disperses. (see Figure 1)

Some local governments positively restraint use of the price

auction with public invitation, on the other hand other procurers

have negative attitudes to the transition towards adoption of

more competitive auction.

In this presentation, we examine why these types of different stance occurs by focusing on favoritism of the local governments

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１．Introduction

-- The purpose of this presentation <Figure 1> histogram about the ratio of the number of the competitive

tendering by public invitation to total number of auction in 2012

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2. Favoritism in Japanese

Tendering System

Economic reasons of three types of auctions

1) normal competitive tendering

It is well known that simple price auction produces

desirable outcomes. (Vickley (1961), Riley & Samuelson

(1981), McAfee & McMillan (1987))

Competitive mechanism among the bidders plays a

very important role in mitigating the difficulties caused

by the asymmetry of information between the procurer

and bidders.

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Tendering System

2) Scored auction Under more complex situations where the quality of an

offered item is a critical factor, simple price auction may

not be adequate for the procurer.

However, the procurer may be able to achieve the

desirable outcome by designing an adequate scoring

rule and by conducting a scored auction.

(Che (1993) and Branco (1997))

Although the above two tendering system have their economic reasons, price auction with public invitation does not have clear economic reason.

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Tendering System

Since the most significant nature of this system is discretionary selection of participants by a procurer before auction, we consider what factors lead to favoritism in the Japanese tendering system.

(cf) Typically, after a public procurer plans to

conduct an auction of an offered item, it

selects invited bidders who are permitted to

the participation of the auction from the list of

entitled (potential) bidders based on its

discretional standard. 13


Tendering System

① Since a public procurer is interpreted as an

agent for the Congress, it is inevitable for a

procurer to consider interests of them when it

plans and conducts the procurement of an item. (Laffont & Tirole (1991))

---- when the economy of a prefecture heavily depends

on construction firms located in its territory, the

request of protecting them made by its citizens is

considered to be relatively strong.

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Tendering System

---- Since a public procurer supplies goods and services

which are absolutely necessary to the daily life of its

residents, it conclude supply contracts with construction

firms which are able to supply them adequately and

promptly in case there is a contingency.

② Since in Japan fiscal year is very strictly

managed, public procurers have an incentive to

complete the projects until the end of fiscal year.

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Tendering System

Due to this incentive, procurers often avoid the risk

that hinders the adequate completion of the project. This

risk may be revealed when the winner of the auction

goes bankrupt or engages in shoddy work as a mean of

cost reduction that is difficult to monitor by procurer.

Since this type of risk tends to increase when price

competition among bidders is more severe, public

procurer has an incentive to avoid severe price

competition by adopting less competitive tendering style.

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Tendering System

This discussions suggest that local government may select less competitive tendering system such as price competition with public invitation

--- to protect the construction suppliers

located in its territory

--- to avoid the risk which is an obstacle

to the completion of the project.

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3. An Empirical Study on the Effects of

Favoritism on Tendering System adopted by

Local Governments

In general, owing to favoritism, when the relative importance of construction industry in the territory increases a prefecture’s incentive to protect them is considered to be strong.

In addition to this, because of strict management of fiscal year in Japan the risk of hindering the completion of planned projects is increased as the competitiveness among bidders in the prefecture is more severe.

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3. An Empirical Study on the Effects of Favoritism

on Tendering System adopted by Local

Governments

<Hypothesis>

The ratio of the number of price competition with

public invitation to the number of auction is

increased

--- when the ratio of the value added in the

construction industry in the territory to gross

prefecture product is high

--- when the relative competitiveness of price

auction with public invitation is relatively low.

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Governments

Estimated equation (using panel data):

RATIOit=α＋ΣβＸit＋μi＋εit

dependent variable (RATIOit):

the ratio of the number of price competition with

public invitation to the number of auction of

prefecture i in year t.

(source) Nikkei Construction’s survey.

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3. An Empirical Study on the Effects of

Favoritism on Tendering System adopted by

Local Governments explanatory variables: LOCAL: The ratio of the value added in the construction

industry in the territory to gross prefecture product. (source) Japanese Cabinet Office, Gross Prefecture Product

COMP: Ratio of average number of the winning bid to reserve price in price auction with public invitation to one in simple price auction.

(source) Nikkei Construction.

SIZE: Average amount per contract. (source) Nikkei Construction, Survey on Orders Received for Construction

(by MLIT).

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Governments

Variables Obs. Means Std.Dev. Min. Max.

RATIO 225 0.513 0.356 0 0.999

LOCAL 235 0.657 0.015 0.038 0.128

COMP 195 1.034 0.383 0.945 1.338

SIZE 228 28.364 17.618 6.500 141.539

<Table 2> Summary Statistics of the variables

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Governments

Using these data, we conduct very simple panel analysis. The results of fixed effects model based on the above equation show that the coefficients of both LOCALi and COMPi have positive values in both estimation. On the other hand, SIZE does not effect the choice of tendering system.

↓

It means that the increase in LOCAL and COMP increase RATIO at 1% significance level.

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Governments

Estimation 1 Estimation 2

const. -0.97 -1.00

(-2.98***) (-3.14***)

COMP 1.11 1.12

(3.69***) (3.70***)

LOCAL 6.10 6.09

(3.24***) (3.23**)

SIZE 0.0008

(0.28)

N 195 195

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4. Conclusion

Focusing on the discussions of favoritism in auction theory, we clarify that the incentive to adopt price competition with public invitation depends on the importance of construction firms located in the territory and the competitiveness among bidders in the prefecture.

(cf) Notice that the favoritism by Japanese local

governments is based on not only their

concern about the conditions of local economy

but also the situation of management of

Japanese fiscal year system.

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4. Conclusion

However, favoritism may substantially facilitate

collusion among bidders and/or corruption in a

stochastic changing environment (Lambert-Mogiliansky & Sonin (2006), Celentani & Ganuza (2002)).

↓

It is necessary for the public procurer to design a

tendering system which reduces favoritism. This

raises a challenging problem for a society.

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Thank you very much for

your time and attention!

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Business

Ippc2014presentation