The False Market of the Low Bid

March 10, 2015

Cross-post from Code for America Team Pittsburgh’s blog.

“Low bid” theory drives much of government goods and services purchasing. For these items, government purchasers can take only price into consideration. While, the system is theoretically designed to drive down government costs and provide a check against corruption, in practice purchasers often end up with subpar goods and services and a dramatically distorted marketplace.

Why do governments use low bid purchasing?

In a perfect marketplace, the theory makes total sense. The lowest bidder would represent the best value in this case because it would be selected from a market of interested and competent businesses. Governments have additional responsibility because they use taxpayer resources. The expenditure of public money separates government purchasing from corporate and business purchasing; governments should take extra care in selecting low bids in order to preserve taxpayer resources. Because marketplaces are rarely perfect, though, the system often ends up with scarce taxpayer resources being used to purchase below-market, often poor quality goods and services.

Where does the low bid come up short?

One core assumption about efficient markets is that information is transparent between all different parties. In government purchasing, however, information is often opaque at best and entirely blocked at worst. Information about bids is often locked up in difficult to navigate websites or buried in PDF files that are difficult to read and understand. Government purchasers often don’t release information about their budgets for different items. This is sensible, because if the budget were published, businesses would be incentivized to bid exactly at the budgeted amount, not at the value of the good or service provided.

The lack of information leads to businesses submitting prices from all over the map. Businesses might dramatically (and incorrectly) underprice or overprice their services. A dramatic underpricing can have wide-reaching implications for a government purchaser.

For example, let’s say a purchasing agent sends out a general purpose service contract for bid. The government’s budget for this service is around $500,000, and the service could be provided reasonably at around $400,000. After the bid period is over, the government has received three responses: $550,000, $410,000, and $200,000. This is a pretty big spread. While the first two are priced closely to the fair market value of the opportunity, the third is a clear outlier. If the market value of the service is $400,000, how can the service be provided at only half that? In all likelihood, it can’t be. The service provided will likely be of very low quality and/or it won’t be provided at all. However, due to low bid requirements, the purchaser is forced to award the bid to the $200,000 vendor.

After the award, the purchaser is celebrated for cutting costs in this area, but the implications are deeper. The services provided end up being very poor, simply because it is not possible to sustain service at those very low rates. Then, in the next year, the budget has been cut from the original $500,000 down to $200,000. Now, there is a compounded problem – the government can only afford cut-rate poor service: accurate pricing of the service is impossible, and a false market has been created where only the cheapest and lowest quality service providers can operate.

What can be done about this?

One possible solution is to give government purchasers the flexibility to choose a lowest responsible bidder instead of simply a low bidder; award the bid based on preset criteria, including but not limited to price. Instead of choosing the $200,000 vendor simply because it is the cheapest, a purchaser might consider that the $410,000 can provide excellent references. This solution carries potential downside risk: it is easier to exploit. However, this downside risk can be mitigated through transparency around both the selection criteria and the selection process. Overall, though, it is better to assume this risk and take steps to mitigate it than to create these false market scenarios.