Contracting for Infrastructure Projects as Credence Goods

• Author: JIANPEI LI,UWE DULLECK,JIONG GONG
• Published date: 01 June 2015
• Date: 01 June 2015
• DOI: http://doi.org/10.1111/jpet.12117

CONTRACTING FOR INFRASTRUCTURE PROJECTS AS

CREDENCE GOODS

UWE DULLECK

Queensland University of Technology

JIONG GONG and JIANPEI LI

University of International Business and Economics

Abstract

Large infrastructure projects are a major responsibility of

urban and regional governments, who usually lack exper-

tise to fully specify the demanded projects. Contractors,

typically experts on such projects due to experience with

similar projects, advise of the needed design as well as the

cost of construction in their bids. Producing the right de-

sign is costly. We model such infrastructure projects taking

into account their credence goods feature and the costly

design effort they require and examine the performance of

commonly used contracting methods. We show that when

building costs are homogeneous and public information,

simultaneous bidding involving shortlisting of two contrac-

tors and contingent compensation of both contractors on

design efforts outperforms sequential search. If building

costs are private information of the contractors and are

Uwe Dulleck, School of Economics and Finance, Queensland University of Technology,

Brisbane, QLD, Australia (Uwe.Dulleck@qut.edu.au). Jiong Gong, School of International

Tradeand Economics, University of International Business and Economics, Beijing, China

(JohnGong@gmail.com). Jianpei Li, School of International Trade and Economics, Uni-

versity of International Business and Economics, Beijing, China (LiJianpei@uibe.edu.cn).

We are grateful to Stuart McDonald, two editors, two anonymous reviewers, and confer-

ence participants at the European Economic Association meeting 2013 for helpful com-

ments. We thank Stuart Beatton for discussing the engineering and project management

literature on this topic with us. Financial support from the National Natural Science Foun-

dation of China (No. 71002001), Program for New Century Excellent Talents in University

(NCET-13-0726), and the Australian Research Council Discovery Grant (DP110103653) is

gratefully acknowledged.

Received December 1, 2013; Accepted December 6, 2013.

C2014 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 17 (3), 2015, pp. 328–345.

328

Contracting for Infrastructure Projects 329

revealed to them after design cost is sunk, sequential search

may be superior to simultaneous bidding.

1. Introduction

Large infrastructure projects, such as public transportation, public utility

facility, and environmental restoration, are often initiated by government.

The complexity of these infrastructure projects is typically beyond the exper-

tise of government, whereas contractors usually have the needed expertise

due to these firms’ specialization.1Project outcomes are to a large extent

nonverifiable—anecdotes abound in which a defect in design or implemen-

tation is not discovered until the project has been in use for many years. As

a result, contracting for infrastructure projects exhibits the feature of cre-

dence goods:2on the one hand, it involves eliciting from potential contrac-

tors information about which way of implementation fits the need of the

procurer the best; on the other hand, whether the services provided fit the

best need of the procurer is ex post nonverifiable, and thus it is impossible to

condition the contract upon the outcome of the project.3

Furthermore, these infrastructure projects typically involve nontrivial

and costly prebuild design. Most existing contributions incorporating pre-

build design leave aside the costly design problem by either assuming costless

design or design effort is observable and a fair design fee can be imposed.

Even if the buyer could offer some design, such design maybe incomplete

and extensive contractor efforts are required to make such design workable.

We extend the public procurement literature by exploring infrastructure

projects’ credence goods nature, while incorporating a costly prebuild design

phase with unobservable design effort in the procurement process. In our

model, a project requires nontrivial input of the suppliers before it is built.

The input of the suppliers can be a design of the project, a construction

plan or a choice of the implementation method to meet a specified outcome

1Oftentimes, the government initially has no clue about the design, and it is the contractor

or a third-party design house that provides a candidate design. We focus on the former case

in this paper.

2Darby and Karni (1973) first introduced the term “credence goods” to refer to the type

of goods or services where a buyer does not know the exact specification of the goods or

services she needs while the supplier is able to determine this need. Besides infrastructure

projects, medical services, repair services, and various types of consulting and advisory

services belong to this broad category. For studies on credence goods, see, for example,

Pitchik and Schotter (1987), Wolinsky (1995), Emons (1997), Fong (2005), Alger and

Salani´

e (2006), and Dulleck and Kerschbamer (2009). Dulleck and Kerschbamer (2006)

provide a comprehensive survey of the research done on this topic.

3As argued by Leslie Ruddock, “Construction goods are typically quasi-credence

goods...in such relationships, the principal employs an agent for a specific task and the

agent possesses information that is not available to the principal...” See Ruddock (2008,

p. 171).