(This essay was published in Hong Kong Economic Journal on 8 June 2016.)

 

Statistical analysis of bidding patterns reveals evidence of rigging in Hong Kong’s residential housing market, according to the Competition Commission, which studied over 700 confidential tender records from 500 maintenance projects provided by the Urban Renewal Authority and the Housing Society.

 

Needless to say, there has been a huge public outcry. The public seemingly has had its suspicions confirmed and human greed is being fully blamed for the wrongdoing of these consultants and contractors. The public will be more impatient now that the smoking gun has been found. Previously, one could only smell smoke in the air. Still, it may not be easy to identify the culprit who pulled the trigger on that gun.

 

The Commission is wise, however, to caution that their findings were not conclusive proof of collusion “having actually taken place.” This is correct. To prove guilt, the prosecutor needs concrete evidence of wrongdoing in specific cases, not statistical evidence of bidding patterns that could still be interpreted in different ways.

 

Statistical correlations, no matter how significant, can have false positives and false negatives. What we have is a research paper, not legal evidence that can be used by a prosecutor. Proving guilt will “require further investigation,” and the process could be long and costly, and the outcome uncertain.

 

Nevertheless, the statistical evidence that has been uncovered is highly significant. What should the government do? How should the Competition Commission proceed?

 

Public opinion naturally focuses on business greed and insufficient government vigilance to either prevent or stop it. Greed is, however, a very poor predictor of the presence or absence of bid rigging and of industry cartelization. Are businessmen who don’t rig and manipulate bids or cartelize any less greedy than those who do?

 

These public organizations follow government procurement practices, and their behavior and choice of selection criteria also follow suit. The single most important consideration of these public bodies is always accountability. For public officials, being caught corrupt over $1 is a worst crime than wasting $1 million.

 

Government procurement practices invariably go for the lowest bid because it is the easiest way of handling public accountability. The use of private information about the bidders is often avoided out of fear of having to defend the choices in contested decisions. The natural outcomes are subsequent cost overruns and suspicious bidding patterns. It is hardly surprising that the Competition Commission has discovered persistent patterns of underbidding.

 

Another concern public officials have is whether the winning bid will successfully complete the project. For a public official, a project that fails to be delivered (for example, the winning bidder subsequently goes bankrupt) will be a huge embarrassment.

 

So if one has to go for the lowest bid while also trying to minimize the risk of the project failing, then one would always pre-qualify bidders with a strong track record. As a consequence, the government procurement process unavoidably sets up barriers to entry that favor industry incumbents and cut down competition.

 

Even when pre-qualification is not used, the long bureaucratic delays in getting paid or the posting of substantial bonds would deter smaller companies and newcomers from bidding for public projects. The long and short of it is that only industry incumbents that can navigate the process of bidding for public projects and afford costly bonds and bureaucratic procedures will survive the game.

 

In a nutshell, the public bidding and procurement process is not designed to encourage competition, but to address public accountability concerns and minimize the failure risk. The final bill is inevitably costly, and the bids will be low but with frequent accompanying cost overruns.

 

Industry cartelization and bid rigging are themselves often a product of these public procurement practices that make it difficult for new and small businesses to enter the game. The barriers ensure that the same industry incumbents are the only players around. This game of repetition makes it possible for industry incumbents to develop those mysterious telepathic powers that help them to cartelize successfully.

 

If greed drives business to cartelize, then greed will also drive business to cheat on the cartel. Cartels are inherently unstable because cheating on the cartel must be the easiest way to making a killing. Cheating can only be prevented if cartel members are able to monitor each other’s behavior and punish violators.

 

If incumbents cartelize successfully then their greatest enemies are new businesses, who are naturally not members of the cartel and cannot be beholden to industry incumbents. New challengers will be facilitated if, and only if, barriers to entry are low. Yet public projects naturally discriminate against new entrants by virtue of their higher entry barriers, with the result that industry incumbents are naturally in favor. The higher that barriers become, then the more likely over time that the industry will become cartelized with bid rigging.

 

Estate renovation work has become exorbitantly expensive since the Operation Building Bright Scheme was introduced in 2009 targeting buildings that are at least 30 years old. Since 2012, it has been mandatory to carry out inspections on all private buildings older than 30 years.

 

It appears to me that the main reason why renovation costs are now exorbitantly high and a lucrative mine for bid rigging is the requirement that the contractors and sub-contractors be chosen from an approved list. This is a hugely effective barrier to free entry. Even if the list is updated from time to time, the barriers are likely to be insurmountable for newcomers.

 

The Competition Commission could learn from the experience of the Independent Commission Against Corruption, whose Corruption Prevention Department regularly reviews government regulations to minimize the probability that they will lead to opportunities for corruption. The Competition Commission could similarly review government regulations and procedures, including bidding rules and the criteria used, to see if they reduce market entry, induce cartelization and lower economic efficiency, and impede competition.

 

Needless to say, government departments should also be prepared to work together towards such a goal, including changing their current regulatory practices and procedures.

 

Economic research, especially in the theory of auctions and game theory, has considerable insight to offer. While there may not be a foolproof way to prevent every form of bid rigging and cartelization, some ways are certainly better than others. Indeed, the Competition Commission is in an excellent position to build up its economic analysis and knowledge with their powers to investigate and demand information.

 

In 2011, I wrote against the enactment of a competition law fearing that it was more likely to impede market competition rather than promote it. I have always believed that the most uncompetitive features of market competition in Hong Kong are due to government regulations and government monopolies. And these are pervasive, from the market for school textbooks to planning rules in development.

 

It is a mistake to believe that greed is the primary driver of bid rigging, cartelization, and the lack of competition. Greed leads to competition, but competition may be so cutthroat that businesses wish to limit it through cartelization. Cartelization is costly and difficult without the help of government regulation to limit market entry.

 

When government steps in, greed drives business to capture government to help them to police market entry and resolve the challenges of cheating on the cartel among members.

 

Two years ago The Economist magazine designed an index of crony capitalism. Behind the crony index is the idea that some industries are prone to “rent seeking”. This is a term economists use when the owners of an input of production—land, labor, machines, capital—extract more profit than they would get in a competitive market. Cartels, monopolies and lobbying are common ways to extract rents. Industries that are vulnerable often have a lot of interaction with the government or are licensed by it, of which building renovation work is a prominent example. Hong Kong was ranked first in the world.

 

Government regulations are the key source of most forms of non-competitive market practice in Hong Kong. Key sectors in the economy suffer from this ailment, and it would be a great service if the Competition Commission would use its powers granted by legislation to bring about some improvement.

 

 

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