The Problem of Predatory Bidding in Competitive Tenders – a Swedish Case Study Paper prepared for the 1st Conference on Railroad Industry Structure, Competition and Investment Toulouse, November 7-8, 2003 Gunnar Alexandersson & Staffan Hultén EFI / Stockholm School of Economics P.O. Box 6501 SE-113 83 Stockholm SWEDEN phone: +46 8 736 95 57 fax: +46 8 33 43 22 e-mail: Gunnar.Alexandersson@hhs.se Staffan.Hulten@hhs.se

1. Introduction 2. Low bids in tenders – is there a problem? 3. The legislator’s view on low bids in tenders 4. A recent case: the tender of the train services to Northern Sweden Costs, revenues and subsidies in detail What do previous tenders of train services show? 5. Discussion and conclusions

Why do firms place low bids in tenders? The desirable case: Unique competence Innovative ideas on production methods Economies of scale/scope

Why do firms place low bids in tenders? Three different types of less desirable explanations: 1. To force competitors to leave the market 2. A subsidiary to the procuring organisation places a bid that, if it turns out to be impossible to fulfil, presupposes more money from the owner 3. Carelessness or ignorance

Predatory Pricing A firm, usually an incumbent, is dumping prices with a consciously calculated loss, or is able to use profits gained in other branches of its business through cross subsidisation Hits competitors first, making them exit the particular market. Then consumers are affected, facing higher prices and worsened supply. Difficult to separate predatory pricing from fierce but healthy price competition

Predatory pricing - does it exist? Industrial economists: looking at historical evidence The Chicago School: Predatory pricing is rare if existing at all since it is seldom or never rational. This is because: a) it is costly b) it is difficult to recoup by future monopoly profits Later theory development, e.g. decision and game theory: Strategy may be rational in the presence of asymmetric information Aggressive pricing has a strong signalling effect, deterring entry Irrational from a profit-maximising perspective may be rational when other objectives are taken into account.

– some special circumstances Public procurement – some special circumstances Procuring entity has a strong position as a buyer, sometimes close to a monopsonist The winning bidder enjoys a monopoly-like position during the contract period, but its actual powers are often very restricted in terms of pricing and supply levels End consumers (when present), are bound to use the supplier chosen by the procuring entity Bids that imply low profitability create a risk that the supplier will not be able to fulfil the conditions of the contract, causing interruptions in delivery If problems arise, shifting to another supplier is seldom an option in the short run, not even for the procuring entity

The legislator’s view on predatory pricing America (U.S. and Canada): Key question: is recoupment possible? Market structure is crucial If entry barriers are low – don’t investigate further

The legislator’s view on predatory pricing European Union: Does not consider predatory pricing as such; instead, focus is on price reductions as one of several practices related to abuse of dominant position Price reductions considered serious whenever practised by dominant firms and aimed at specific competitors Successful strategy or not does not really matter Relevant market is an important issue

The tender of the trains to Northern Sweden Background Passenger train services (mainly night trains) running from Gothenburg and Stockholm to the very north of Sweden Tendered seven times since 1992 Net cost contract New tendering authority, Rikstrafiken, established in 1999-2000 SJ (former monopolist) won the first five tenders Tågkompaniet won the 6th tender, entering in January 2000 Implied a reduction in subsidies from 122 million SEK/year to 114 million SEK/year (on average) Connex won the 7th tender, entering in June 2003 Implies a reduction in subsidies to 62 million SEK/year (on average)

Table 1: The bids of Connex and Tågkompaniet in Rikstrafiken´s tender of the Northern trains (million SEK)

Conclusions Likely case of predatory bidding Procuring authority has not investigated bids thoroughly Costly legal aftermath likely Need for reformation of procurement and competition regulation: 1. Alternative forms of procurement? 2. Measures for determining when bids are too low 3. Take into account the size of firms entering new markets 4. Consider the problems related to fulfilment of low bids in the service sector