3 (plus 1) Economic Principles Every Procurement Person Should Understand

Procurement isn’t a purely economic activity, but that doesn’t mean economic principles don’t apply to procurement. Actually, it’s quite the opposite.

Whether you realise it or not, your procurement practices are influenced, driven and affected by a number of economic principles – including the ones they didn’t cover in “procurement class”.

Over the years, I’ve found that in almost every organisation, procurement practices, efficiency and performance can be improved by applying some key, lesser-known economic principles. So in today’s blog, I’m sharing those principles with you.

Deadweight loss

Deadweight loss is the loss of “economic efficiency”. It occurs when you pay more for a product or service than you may otherwise have had to, or when the cost of a product or service exceeds the benefit it brings.

Classically, deadweight loss is caused by market monopolies, taxation, subsidies and binding price floors and ceilings.

For example, in the case of a market monopoly, rather than competing producers selling widgets for $1 each, one monopolistic producer may charge $6 for widgets. The deadweight loss is the difference between these prices – in this case, $5. Similarly, with taxation, the $5 widget you need may attract tax but a similar $5 widget doesn’t, making the deadweight loss the amount you pay above this $5 base price.

Now you may be wondering: what the heck does this have to do with the price of bananas in procurement?

Obviously, you can’t control monopolies, taxation, subsidies and the like. But while this classic deadweight loss might be out of your control, your procurement processes may be creating what I call “artificial deadweight loss”.

Every hurdle you institute in your procurement processes creates a deadweight loss for your organisation.

This deadweight loss shows itself in higher prices you pay by only testing an artificially restricted market. When you limit competition with a small subset of approved suppliers (even if you market test, you’re testing in a smaller market, so you’re paying more), you are creating a potentially increasingly uncompetitive tendering environment.

So, if every piece of regulation or control creates additional cost, should we throw the rules out??

Well, not quite.

But it’s vital that you take a considered approach to your procurement rules to minimise  deadweight loss.

This means you should only have as many procurement controls as absolutely necessary, not one iota more. That includes examining your processes from a supplier’s perspective and making it as easy as possible for a supplier to do business with you, for example, by lowering the barriers to entry for small buys.

Any barrier to your team or your suppliers that isn’t necessary and defensible needs to go.

Prisoner’s dilemma & game theory

The prisoner’s dilemma is a classic game used in game theory to analyse the likelihood of people cooperating or competing with one another.

In this game, two criminals from the same gang are imprisoned in solitary confinement, without means of communicating with one another. The prosecutors only have evidence to convict them both for a lesser charge. Simultaneously, the prosecutors offer each criminal a deal to betray the other. If both criminals betray one another, they’ll each serve two years. If neither criminal betrays the other, they’ll each serve one year in gaol. But if one criminal betrays the other while their comrade remains silent, the criminal who betrays will walk free while the silent criminal will serve three years.

Obviously, the best mutually beneficial outcome occurs when both parties cooperate and stay quiet. However, as a higher individual reward can be achieved through competition rather than cooperation (zero years in gaol as opposed to one), game theory suggests that two purely rational players would decide independently to betray one another (though this actually leads to the third best outcome: two years in gaol rather than one or none).

Of course, game theory describes the outcome if the prisoner’s dilemma was played by purely rational decision-making. In real life, the human tendency towards cooperation can yield different results.

The tendency to cooperate also increases if the game is played for several rounds rather than once, as the additional rounds offer the opportunity for a player to punish the other for past behaviour. In this situation, even game theory agrees that cooperation becomes the rational choice to make.

Now perhaps you’re wondering: Where am I going with this?

Well, rather than people roleplaying in a game as prisoners, in procurement you have two parties: a buyer and a seller. Just like in the prisoner’s dilemma game, these parties can “compete” and act in their own self-interest, or “cooperate” and act in a manner that’s mutually beneficial.

If we apply what we’ve learned from the prisoner’s dilemma, we know that the question of whether cooperation or competition is in each party’s best interests depends on how many “games” will be played.

In a one-shot environment (such as a one-off contract), both the buyer and seller will push their own self-interest. For example, the buyer may push for the lowest possible price while the seller, knowing this is a one-off gig, will push for the highest price.

I’ve seen this happen so many times, and the reality is that when both parties’ approach is to squeeze as much as possible from a deal, everyone loses. I’ve seen procurement teams with multi-million-dollar budgets try to squeeze a few more thousand from a contract only to end up with a cheaper – and sub-par – supplier. Some of the most expensive mistakes in procurement can come from going with the “cheapest” option in this way (remember, cheap is not the same as affordable!).

In contrast, if you set the expectation that your supplier’s performance will affect whether you work with them in the future, they’ll put more effort, time and/or money into improving (or maintaining) service delivery. After all, if this isn’t just a one-shot contract, it’s in their interest to invest in an ongoing relationship rather than squeezing as much as possible from a one-off deal before moving on.

So as you can see, the prisoner’s dilemma and game theory teach us about managing your supplier relationships. And this is something I see organisations struggling with all the time.

Too often, organisations demonise the idea of business relationships because they’re concerned that if they become a little too comfortable with one supplier, that supplier will leverage the organisation to pay more.

But the reality is that there is nothing wrong with having strategic relationships with suppliers. Stable, long-term, valuable supplier relationships are much more likely to help rather than hurt you. So long as your agreements are commercial, there’s also nothing wrong with buying more from your existing suppliers and not competing in the marketplace or treating good suppliers preferentially to preserve the relationship. (You can still choose to test other suppliers, have other scopes of work or break up scopes, too. Like I said, it needs to be commercial.)

Having a supplier that’s profitable is also not an evil (another common – and utterly ridiculous – notion). If your supplier likes doing business with you and they’re making money, they’re incentivised to look after you.

Great supplier relationships also become better risk mitigation than any contract you could ever put together because your interests are aligned.

Market structure & competition types

Economic theories describe three main types of market – a balanced market, a hypercompetitive market and an uncompetitive market.

In balanced markets, there’s a healthy and realistic degree of competition between vendors. Uncompetitive markets, on the other hand, have limited or no competition. These may occur when a monopoly/duopoly dominates the market. In hypercompetitive markets, unsustainable price wars drive the rapid escalation of competition. Because they’re unsustainable, hypercompetitive markets tend to exist only for the short-term. And while the idea of low prices may sound attractive, this form of competition can ultimately hurt both the vendors and their consumers.

On a larger scale, the effects of these markets on procurement may be basically self-explanatory.

But what you may not have considered is how you can inadvertently create mini-markets with their own structures and competitive flows.

In procurement, your category managers (or procurement manager if you don’t do category management) build their own mini-markets when they approve suppliers or shortlist businesses that your organisation can deal with. These are the people you’re sent to at the beginning of the tendering process – a mini-market inside the real market of suppliers that exists out there.

Unfortunately, most managers don’t stop to consider whether the mini-market they’ve created is an environment that promotes balanced competition, hyper-competition or next to no competition at all. And this can create all kinds of problems.

Government organisations are a classic example.

Government organisations often inadvertently create mini-markets with monopolistic competition scenarios. This occurs because they use panel prequalification processes which cut out many price competitors, then only release tenders to the selected businesses that are left. These businesses become known in the organisation and get selected for more tenders thanks to selection bias, which in turn leads to less effective competition. (This is different to having a positive ongoing relationship with preferred suppliers, which we discussed before.)

This phenomenon can also occur in corporate and not-for-profit organisations, though it’s less prominent because these organisations tend to have procurement functions that are more focused on outcomes over processes. And all organisations can inadvertently create mini-markets with hypercompetitive tendencies.

That’s why one of the best things your procurement team can do is spend less time on administration, paperwork and other “process” issues, and take more time to analyse and understand the mini-markets your organisation has created and the competitive dynamics within those markets.

Essentially, you want mini-markets that are deep enough to encourage a level of price competition (a balanced market) rather than a monopoly (an uncompetitive market). However, take care to ensure that your mini-markets aren’t so deep that your suppliers start scrapping quality below what you’d prefer to maintain margins and compete in a price war.

Resource vs non-resource markets

Ok, so this one isn’t exactly an economics concept, but it’s strongly related and worth mentioning. It’s our plus one for the day.

Many organisations don’t understand the difference between resource and non-resource markets. Instead, they make the mistake of thinking that every market is selling a commodity.

But the truth is, not everything on the market is a commodity. In fact, most of the things your organisation buys are probably a combination of commodity inputs and value-add.

In this arena, where procurement tends to fundamentally fail is by treating goods which are IP-based (such as consulting services) or systems-based (such as large IT system procurements) as commodity goods that are easily comparable between suppliers.

However, all too often, this leads to comparisons between apples and oranges. Actually, the result is often worse. It’s more like comparing apples to a Volkswagen Golf.

You see, the truth is that most things aren’t commodity goods, even though people treat them like they are. And the issue is that when you’re buying non-commodity goods (including IP-based and systems-based goods), your processes and procedures need to be more flexible, and allow for the fact that the goods are not necessarily the same (even when addressing the same scope0.

You should allow for the fact that different suppliers will offer different value-adds and different value chains. Most importantly, they’ll have fundamentally different risk profiles.

Now you can do desktop analysis as much as you like in these situations, but you’ll really only get some measure of truth in terms of quantifying each supplier’s value adds, value chains and risk profiles.

Between fundamental communication problems and bias, plus the issues inherent to any two organisations’ attempts to communicate with one another under procurement probity guidelines, the scope for misunderstanding is huge. As a result, organisations don’t understand the value or the risks that may be involved, and so they favour a basic measure like price over any understanding of the quality of the commodity they’re buying.

Ultimately, once you’ve done a basic level of due diligence on an IP or systems supplier, the only way to truly understand their product is to use it. Don’t waste weeks or even months, trying to analyse possible performance and a host of other variables. Instead, do a small buy or trial period or some other smaller commitment and get a thorough understanding of the product by actually using it. This is the only way to truly understand, compare and evaluate non-commodity goods.

Voila!

They say that information is power, and that’s certainly what I’ve tried to provide you with today.

Now you know the impact of some lesser-known economic principles on your procurement, you have the information you need to mitigate – or leverage – their effects.

Like what you’ve read?

Then you’ll also like new e-book, Beyond category management – new thinking in procurement teams, which is available here.

You can also check out my previous blog articles on procurement savings  here and how to make your shared services procurement function more client centric here.

Thanks for reading!

 

Adam Stennett
Stennett Consulting