PRICE ADJUSTMENT POLICIES AND FIRM SIZE

I. INTRODUCTION By the fall of 2009, several State Departments of Transportation in the United States adopted price adjustment policies to mitigate significant fluctuations in the cost of oil-based inputs in government procurement. Price escalation in oil-based materials, such as asphalt binder or fuel, was the main cause behind the trend. Firms increased bids to offset higher input prices, adversely affecting procurement costs (Damnjanovic et al. 2008). Because inputs like asphalt experienced significant cost increases (e.g., the price of alphalt increased by 31% in 2005 alone), it is not surprising that contractors in general, and small firms in particular, struggled with construction budgets. In response to the growing uncertainty, many states introduced price adjustment policies for related inputs, effectively dampening losses and profits at times of unanticipated cost fluctuations. (1) While the latter part of last decade saw notable oil price price deviates beyond a certain range of the baseline index, increases, in the recent months firms enjoyed cost savings, a percentage of which can be passed on to Departments of Transportation with the establishment of this policy. Going beyond industries directly impacted by uncertainty in oil prices, the provisions investigated in this paper are common in defense contracting, and were added to the health care law in what came to be known as "risk corridors." (2) As an example, the Department of Defense has embedded such provisions in fixed-price contracts with economic price adjustment (FPEPA). These measures are designed to limit contractors' exposure to economic uncertainty and market volatility prevalent in long-term fixed-price arrangements. (3) In the same spirit, the Regional Greenhouse Gas Initiative, an emission-permit trading program involving nine northeastern states in the United States, held down price escalations by placing a price collar on allowances that limits variability. We investigate the effect of the price adjustment policy on firm bidding behavior and competition intensity in road construction in Oklahoma, which can offer insights on the effectiveness of implementing such policies across industries. We use data on public construction auctions to study the effect of this policy on firms of different sizes, where size heterogeneity is a defining characteristic of the market (Cho 1986). The construction industry displays market concentration featuring a small number of strong contenders. From the pool of over 150 participants in our sample, the 11 firms that won most frequently were awarded over a quarter of auctioned projects and more than 38% of contracted value. Compared with the manufacturing sector surveyed in Audretsch and Mahmood (1995), a notably higher percentage of new construction companies end up failing. Many undersized and startup builders compete on the margin and have a low chance of making it to the list of long-term players. The literature has identified a strong correlation between firm size and financial solvency in association with firm survival and growth (see Brito and Mello 1995 and Hubbard 1998). In what follows, we frame our empirical analysis with a theoretical model highlighting this connection. As noted by Gertler and Gilchrist (1994) and Martinelli (1997), there are asymmetric changes in firms' borrowing costs when financial constraints are tightening in the face of uncertainty, and they depend on the level of capital accumulation. As a result, high volatility in input prices is likely to reinforce the imbalance among competitors of different sizes. (4) Price adjustment policies help to level the playing field between small and large firms without invoking differential treatment toward a group. Finally, there has been considerable interest in the literature in various policies that Departments of Transportation around the country use to help small businesses, such as bid preference policies and setasides (see, for instance, the work of Denes 1997, Marion 2009, Krasnokutskaya and Seim 2011, and Athey, Coey, and Levin 2013). …