This study evaluates the effect of incomplete contracts on subcontracting arrangements and the framework of procurement sales. Construction contracts are considered to be incomplete since they are influenced by unexpected events, whether it is an external environmental element, an error in the design, or an unidentified site condition (Miller, 2014).
The paper has two main objectives. First, Miller (2014) quantifies how measures of contractual incompleteness influence contractors’ expenses. For this same objective, the author separates the expense effects of both sub-contracting and in-house arrangement. The paper reviews a considerable size of abstract and empirical literature regarding incomplete contracts as well as the make-or-buy literature. The literature predicts the make-or-buy decision founded on a tradeoff between cost savings incentives and the probability of hold-up expenses. This paper mostly reviews developing literature that measures the effect of organizational boundaries on economic consequences. By putting less emphasis on performance outcomes, the author ends up making conclusions on the most important economic outcome, which is costs. While performance outcomes are interesting, they only have a limited influence on make-or-buy decisions. By the author focusing on economic outcomes, he can effectively draw a distinction between ex ante contract creation and ex post contract implementation. The literature predicts that both ex ante expenses of incentive alterations and ex post bargaining expenses are important determinants in the make-or-buy decision. Also, the paper uses a structural approach which enables the author to carry out counterfactual exercises. For instance, the cost-benefit evaluation is aimed at measuring a costs savings strategy if it were to mitigate the incompleteness of contracts. The author could modify regulations that alter subcontracting patterns.
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The second objective involves demonstrating how a similar kind of incompleteness alters bidding approaches in the competitive bidding tool frequently employed by departments of transport to get bridges and highways (Miller, 2014). The study proposes a structural valuation method that enables the author to empirically assess the significance of such alterations. The author then proposes a simple modification to the auction theory that would bring better results for bidders and cut costs for procurement agencies. Since it is somewhat difficult to understand the the bidding strategies and auction design, the author presents and elaborate explanation for the auction tool.
The results are first presented on contractual incompleteness, and the author separately discusses heavy industries and ancillary tasks (Miller, 2014). The author then considers other covariates, including scale economies, distance, and fringe status. Finally, the author provides the outcomes on bid skewing and discusses the bias from misspecification.
Findings
This study has three main findings. First, the incompleteness of contracts on overruns has a substantial impact on subcontracting expenses. It has been found that, considered to be a dollar-value elasticity, a 0.1 point increase in quantity deviation results in a 0.045 point rise in unit expense when compared to the blue book value (Miller, 2014). In the other hand, the incompleteness of contracts from underruns has no influence on subcontracting expenses. Therefore, hold-up expenses are reduced significantly if a substantial construction project is carried out internally by the prime contractor. It follows that the differences between underruns and overruns can reveal the kind of hold-up that is taking place.
The second finding involves ancillary tasks, where it is found that for underruns, the incompleteness of contracts as no influence on subcontracting expenses. For overruns, on the other hand, there is a substantial effect on subcontracting expenses (Miller, 2014). In this case, scheduling hold-up is not considered to be relevant since, as tasks carried out at the end, up to twenty-four months after bidding, they can be ignored in the pre-planning stage of schedules. While analyzing the large hold-up resulting from underruns, it was found that sizeable underruns bring about conflicts regarding lost revenue. Thus, contractors lose resources and are unable to recover project-specific fixed expenses.
It was also found that the incompleteness of contracts has a considerable impact on the costs of prime-contracting of ancillary tasks. While such a finding seems to be contrary to the theory of the firm whereby carrying out tasks in-house mostly reduces the dangers of contractual incompleteness, the theory accommodates such an outcome.
The final findings involve fringe status, distance, and scale economies. It was found that distant and relatively bigger companies are likelier to subcontract large projects. These findings are very different in the case of ancillary tasks, where such firms are less likely to subcontract. Also, scale economies have been found to be greater in size for prime-contracting (Miller, 2014). This outcome can be justified by the increasing importance of learning-by-doing on the job site. Subcontractors get less learning-by-doing on a particular task since they are mostly involved in many projects as compared to prime contractors.
The Significance of Subcontracting in Project Management
From the findings, it is clear that subcontracting is not only vital but also has considerable economic implication on project management. Construction companies that carry out the entire project without the help of subcontractors end up sub-using a great amount of human resources and equipment (Miller, 2014). Subcontracting tends to focus the efforts on other activities, outside the production process. Therefore, subcontractors make the project more flexible as it can adapt itself to uncertainties.
For relatively substantial construction projects, subcontracting entails substantial hold-up expenses, especially when scheduling pressures are significant. Regardless, carrying out in-house reduces such costs. Subcontractors tend to have frequent, repeated interactions with local suppliers. Such interactions reduce hold-up complications. Additionally, subcontracting allows for more effective costs control. This means that using subcontractors with fixed price contracts enables costs control and limits the burden of the manufacturer’s supervision.
Reference
Miller, D. P. (2014). Subcontracting and competitive bidding on incomplete procurement contracts. The RAND Journal of Economics, 45(4), 705-746. Retrieved from http://www.webmeets.com/files/papers/earie/2011/628/millerpaperEARIE.pdf
