MICROECONOMICS AT WORK

MICROECONOMICS AT WORK by Morten Hansen

On 11 October the Microeconomics course starts so why not a column related to micro? And a good micro topic suggested by The Insider – this really is micro at work.

One of the biggest players on the demand side for construction works is the public sector: Roads have to be built, bridges have to be reconstructed – even national libraries have to be made now and again. The public sector uses its market power – what we call monopsony, being the only buyer – to suppress the price it pays for construction works via public procurement: You, the construction company, make a tender, i.e. an offer of how cheap you can do the project. The lowest offer gets the contract, saving taxpayers’ hard earned money. The construction companies, i.e. the supply side, are a somewhat limited club so we would typically think of them being described by oligopoly theory: They know each other and they know that their actions – setting prices/supplying or not – will affect the actions of their competitors.

So they all know how annoying it is for them to participate in public procurement. They are forced to compete in terms of setting a low price, which is not what firms are all that happy about and if they know their Bertrand model (and I am sure they do) they also know that such price competition can force the price all the way down to marginal costs.

What to do? Year 2 and 3 already know the answer: Collude, make a cartel, cooperate on offering not-that-low prices in public procurement. Company A promises not to propose a low price for project X, letting company B win the tender with a high price if company A can win with a high price offered for project Y where company B offers a too high price.

Due to collusion, prices end up higher than they otherwise would; firms gain producer surplus and we lose consumer surplus.

Such cartels are illegal exactly for those effects and during the summer and autumn a bunch of Latvian construction companies were fined 16 mill. EUR for colluding on all sorts of projects 2015 – 2018.

Microeconomics at work – and a good example of how micro needs help from the legal sector, here the Competition Council, in order to work properly.

More here if you are interested: Lsm.lv, Construction firms fined 16 million euros for operating huge cartel