Core Concept
Information asymmetry occurs when one party in a transaction has more or better information than the other. In procurement, contractors typically know their true costs and capabilities better than government buyers, creating opportunities for rent extraction and adverse selection.
Key Mechanisms
1. Adverse Selection
- The Problem: When quality is unobservable, low-quality providers can mimic high-quality ones through low bids
- Example: Choosing the lowest bidder may attract contractors who plan to cut corners on materials or workmanship
- Akerlof's Insight: In "The Market for Lemons" (1970), George Akerlof showed how information asymmetry can cause markets to collapse as buyers cannot distinguish quality
2. Moral Hazard
- The Problem: After contract award, contractors may reduce effort or quality since monitoring is imperfect
- Example: Using substandard materials or cutting corners during construction when government inspection is limited
- Mitigation: Performance bonds, inspection requirements, payment tied to milestones
3. Signaling & Screening
- Signaling: High-quality contractors signal competence through certifications, past performance records, or willingness to accept performance bonds
- Screening: Government uses prequalification criteria, technical evaluations, and reference checks to filter bidders
- Trade-off: More stringent screening reduces adverse selection but may limit competition
Development Economics Applications
Infrastructure Procurement:
- Road construction: Quality defects often emerge only after monsoons reveal poor foundations
- School buildings: Safety standards may be compromised when monitoring is weak
- Water systems: Underground infrastructure difficult to inspect, enabling corner-cutting
Health & Education Services:
- Teacher/doctor absenteeism: When effort is hard to monitor, service providers may shirk
- Drug quality: Generic manufacturers may reduce active ingredients when testing is sporadic
- Training programs: Providers may report inflated attendance or outcomes
Policy Solutions
Contract Design:
- Two-part bidding: Evaluate both price and technical quality with weighted scoring
- Performance contracts: Payment tied to verified outcomes rather than inputs
- Revelation mechanisms: Incentive-compatible contracts that induce truthful cost revelation
Institutional Mechanisms:
- Third-party certification: Independent quality assurance reduces information asymmetry
- Reputation systems: Public databases of contractor performance enable better screening
- Citizen monitoring: Community oversight (e.g., MGNREGA social audits) supplements government inspection
Technology Solutions:
- E-procurement platforms: Increase transparency and reduce collusion opportunities
- GPS/sensor monitoring: Real-time tracking of materials and work progress
- Drone surveys: Cost-effective quality inspection of infrastructure projects
Empirical Evidence
World Bank Road Projects (Olken 2007):
- 27% of materials "missing" in Indonesian road projects on average
- Increased audits reduced missing expenditures by 8 percentage points
- Community monitoring less effective than government audits for technical quality
Indian Rural Roads (PMGSY):
- Quality varies significantly with contractor selection methods
- Two-bid system (technical + financial) produces better outcomes than lowest-price-only
- State capacity for monitoring crucial—weak states show higher quality problems
Market Failures & Efficiency Loss
Information asymmetry creates several types of inefficiency:
- Allocative inefficiency: Contracts awarded to wrong (low-quality) providers
- Productive inefficiency: Excessive monitoring costs needed to ensure quality
- Dynamic inefficiency: Good providers exit market, worsening average quality over time
- Rent dissipation: Resources spent on signaling and screening create deadweight loss
Key Takeaways
- Price alone is an insufficient basis for contractor selection when quality is unobservable
- Optimal procurement balances information acquisition costs against risk of adverse selection
- Context matters: Appropriate mechanisms differ based on state capacity, market structure, and technology
- No perfect solution: All mechanisms involve trade-offs between efficiency, rent extraction, and transaction costs
- Institution-building: Long-run solution requires investing in state capacity for monitoring and enforcement