Public procurement is a very important part of economic activity. It accounts for about 20% of gross domestic product (GDP) in the United States and 16% in the European Union (EU) countries. (1) Therefore, it is not surprising that many interest groups are at the stake whenever aspects of public procurement procedures are discussed. To limit the influence of these groups, the purpose of legislation in the United States and the European Community has been to unify public procurement procedures and restrict the discretionary power of contracting officers and agencies at lower administrative levels. The Federal Acquisition Regulation (FAR) in 2005 in the United States and directive 2004/18/EC of the European Parliament in 2004 are examples of this.
One of the most important aspects in public procurement is the extent to which subcontracting is allowed. Traditionally, subcontracting has been judged negatively. For example, in construction, which amounts to a substantial part of public procurement, the FAR prevents contracts from being awarded to a single firm that supplies both design and engineering services (i.e., it requires contract centralization). However, recently most states have legislations that allow for exceptions like the use of the design-build method (i.e., they allow contract decentralization). Lam, Chan, and Chan (2006) report that nowadays more than one-third of the construction projects in the United States and up to 50% in Japan use the design-build approach. Economic theory should explain whether this is because of the increased influence of pressure groups or if there exists an economic rational for this tendency.
However, economic theory has had difficulty in explaining the superiority of subcontracting. To see this, consider a general contractor (or principal) who needs two suppliers (or agents) to realize a project. Either, he/she can contract directly both of them, or contract only one supplier and let him/her subcontract the other. Subcontracting obviously implies a loss of control over the subcontractee's contract for the general contractor. However, because he/she can always replicate the same contracts if he/she contracts directly with both suppliers, it is not easy to see the advantages of subcontracting. A common assumption in this literature is that the principal has all the bargaining power and can make a "take it or leave it" offer to the agent. Regarding public procurement this is a realistic assumption in cases in which there are many suppliers, but it fails to apply in cases in which the principal only can choose among a small number of suppliers. For example, this is the case in public procurement of defense systems, aeronautic and space equipment, or specific construction facilities such as water depuration plants, airports, or electric power plants.
Although procurement in these cases is also based on fixed-price, cost-reimbursement, and incentive contracts, usually it also allows for negotiations. So, section 15.3 of FAR states that "negotiations are exchanges, in either a competitive or sole source environment, between the Government and offerors, that are undertaken with the intent of allowing the offeror to revise its proposal. These negotiations may include bargaining. Bargaining includes persuasion, alteration of assumptions and positions, give-and-take, and may apply to price, schedule, technical requirements, type of contract, or other terms of a proposed contract." This means that economic theory should take into account that contract design includes bargaining between parties at some stage of the process when contract centralization and decentralization are compared.
To analyze this issue, a very stylized model is used to examine the advantages of centralized and decentralized organizations. Two agents work jointly on a project for a principal. Usually, in public procurement this is a contracting officer who represents a public agency. …