LABOR MARKET REGULATION AND THE WINNER'S CURSE

I. INTRODUCTION In March 1992, the government of British Columbia (B.C.), Canada, introduced the Skill Development and Fair Wage Policy (SDFWP), which mandated the payment of "fair" wages on provincial public construction projects, and promulgated the wage scales for construction crafts. In 1994, SDFWP was enacted as legislation. Similar laws have been enacted in England and the United States in the past, and as Allen's [1983] survey shows, their impact is a subject of controversy. Opponents argue that regulated wages distort the labor market, reduce competition, and increase construction costs. Proponents of the law, on the other hand, not only emphasize its long-term positive effects on the living and working conditions of workers, training, and the consequent productivity increases but also claim that the alleged inflationary effect is counterbalanced by the improved labor and product quality. In this paper I focus on another consequence of wage regulation, namely, its impact on bidding for public construction contracts. I propose that the wage regulation will affect the construction market not only by changing the costs and quality of inputs but also through the transformation of the nature of the uncertainty that the contractors face during the bidding process. The auction theory predicts that the optimal bid is responsive to the type of uncertainty. Under the so-called common values (CV) model, bidders face some common source of uncertainty regarding the construction cost, and the winner is prone to underestimate the "true" cost. Rational (and experienced) bidders avoid this "winner's curse" by adding a surcharge to their estimated cost. As uncertainty assumes a less "collective" and more "private" nature, however, the winner's curse becomes less of a problem and the rational bidder does not need to resort to the additional surcharge as a protection from underbidding. The SDFWP may result in such a transformation in the bidding environment by reducing the uncertainty over labor costs that are common to all (nonunion) contractors. Elimination of the surcharge, in turn, may even offset the possibly higher labor cost. In this paper, I will test indirectly the hypothesis that the SDFWP influenced the bidding environment in B.C. in this fashion, under the working assumption that contractors follow optimal rules in determining bids. For this purpose, I will use data from 54 public school construction projects tendered between 1989 and 1995 and compare the pre- and post-SDFWP unit bid prices. The paper is organized as follows. In section II, I discuss the relevant auction literature and the hypotheses. I state the main hypotheses of the paper concerning the SDFWP and bidding behavior in section III. Section IV describes the data. An empirical model of bid price determination is presented and estimated in sections V, VI and VII. The final section concludes. II. BIDDING AND THE WINNER'S CURSE Bidders for public school construction projects in B.C. submit sealed bids at a specified date, and the lowest bidder wins the contract.(1) Many of the early sealed-bid, first-price optimal bidding models presented in economics, civil engineering, and operations research literatures follow Friedman [1956]. According to these models, bidders are risk-neutral, non-colluding, expected profit-maximizers competing over a single project. Friedman suggests that the probability of being the lowest competitor is equal to the product of the probabilities of underbidding each competitor. Probability distributions of the competitors' bids are to be obtained from the data on previous tenders. This approach lays bare critical elements in competitive bidding. First, the contractor faces a trade-off between profitability and the probability of winning the contract. The bid must be high enough to yield a positive profit and low enough to win over other bids. Second, superior cost efficiency enables the contractor to change the parameters of this trade-off in his or her favor. …