Accountability Challenges in Public Sector Contracting for Complex Products

Trevor Brown John Glenn School of Public Affairs

The Ohio State University 1810 College Road

Columbus, OH 43210-1336 E-mail: brown.2296@osu.edu

Matthew Potoski

Department of Political Science Iowa State University

519 Ross Hall Ames, IA 50011

E-mail: potoski@iastate.edu

David Van Slyke Maxwell School of Citizenship and Public Affairs

Syracuse University 320 Eggers Hall

Syracuse, NY 13244 E-mail: vanslyke@maxwell.syr.edu

Manuscript prepared for the Kettering Symposium on Public Accountability, Dayton, OH,

May 22-24, 2008

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Accountability Challenges in Public Sector Contracting for Complex Products1

Governments buy lots of goods and services. The U.S. federal government spent over

$419 billion in fiscal year 2006 for procurement, almost double 2001 procurement expenditures

(Hutton, 2008). The rationale for buying is to lower costs through scale or market efficiencies,

spark service delivery improvements or innovation through competition, and access expertise or

capacity unavailable in-house (Kelman, 2002). The risks are that contracting’s cost savings are

sometimes illusory, quality suffers, and delivery delayed (Sclar, 2000).2 Some fear that such

large scale procurement undermines accountability: when government purchases rather than

produces, the chain of accountability is extended yet further and perhaps even weakened. People

working for government are more easily held accountable than people working for organizations

that sell to the government. When contracting fails, contracting muddles responsibility: does

fault lie with the seller, the buyer, or unforeseen circumstances that nature delivered?

Contracting produces low risk win-win outcomes when markets function well: markets

need enough buyers and sellers, buyers and sellers need to be well informed about products and

each others’ preferences, and actors must be able to easily enter and exit the market and

exchange resources at low costs.3 Market discipline provides its own accountability by revealing

who is responsible for deals gone bad and then punishing them for their transgressions. Buying 1 This research is partially funded by the IBM Business of Government Foundation. 2 There are other risks associated with contracted service delivery, like nepotism or cronyism. Depending on the circumstances, these risks are also present for internal service delivery. Because so much is made of service quality, cost and timeliness in the comparison between internal versus contracted service delivery, we focus our discussion on these three. 3 There are several ways to view the sources of market failures, including incomplete property rights, transaction costs, and information asymmetries. Goods may be non-rivalrous or non-excludable so that transferable property rights cannot be established and enforced without transaction costs swamping gains from trade (Weimer and Vining, 1999). Historical accident may inefficiently lock in path dependent technologies such as the QWERTY keyboard (David, 1985). Information asymmetries between buyers and sellers may create a “lemon market” where inferior products keep good products off the market (Akerloff, 1970). A common thread in these cases is that the market failure is caused by the transaction costs stemming from limited information among participants, particularly buyers, or from goal incongruence between the buyers and sellers.

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and selling is more complex when the market is thin (few buyers and sellers), buyers and sellers

are uncertain about the terms of exchange, and the future is unpredictable. Complex

circumstances threaten the win-win gains from market exchanges and obfuscate responsibility

for failed exchanges.

Contracting in complex circumstances does not guarantee failure, but it does make it

more likely. Buyers and sellers can no longer rely on market discipline, but instead must manage

their relations to ensure the exchange bears its win-win fruits. In this paper we investigate

accountability issues raised when governments purchase complex products. Our inquiry uses the

simple but powerful heuristic of game theory to show the complexities of accountability

questions in public sector contracting. The outcome of a complex contract exchange is the result

of the buyer’s and seller’s efforts – whether they have made good faith efforts to maximize the

mutual gain the contract can generate – as well as the luck of nature – unforeseen forces make

some apparently difficult tasks turn out to be easier and some easy ones harder. Because the

effects of these factors are generally unknown, it is difficult to determine whether the outcome of

a complex contract was due to a well managed process or fortunate circumstances. Our

theoretical inquiry highlights how buyers and sellers can improve the chances of win-win

outcomes and make the contracting process more accessible and accountable.

This paper is divided into four sections beyond this introduction. In the first section we

distinguish between simple and complex products, and then highlight the risks and rewards of

contracting for complex products. In the second section, we describe the basic bilateral

contracting game. We then use the contracting game to identify accountability challenges in

contracting for complex products. Fundamentally we show the challenges of trying to determine

whether outcomes result from the behavior of the two parties to the exchange or exogenous

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factors. In the third section we provide an illustration of these accountability challenges – the

Coast Guard’s Project Deepwater, a multi-year, multi-billion dollar procurement. In the fourth

and concluding section, we summarize our arguments by highlighting important implications for

contracting practice and accountability.

Simple and Complex Contracting

Successful contracting delivers a win-win exchange between buyer (in our case a

government agency) and seller (a private firm, a nonprofit organization, or even another

government). Buyers seek goods or services that meet their expectations for quality at a price

lower than the value they attribute to the product, while sellers want compensation that exceeds

their costs for producing the good or service. Much of what government buys are what we call

simple products. For simple products, buyers and sellers can easily define cost, quality and

quantity parameters, and there is a vibrant market of buyers and sellers with many exchanges and

clear price, quantity and quality signals. In a market exchange for simple products, the buyer can

describe with a high degree of detail what it wants the seller to do or produce. While a contract

can be specified in a variety of forms – such as inputs and tasks, the outputs, the outcomes, or

some combination of these (Bajari and Tadelis 2001; Heinrich 1999; Martin 2004; O’Looney,

1998)4 – overall, contracts for simple products are relatively complete in the sense that they

unambiguously define each party’s obligations. If for some reason a buyer or seller fails to live

up to her contractual obligations, the transgression is quickly and easily recognized and a richly

competitive market provides a replacement partner seeking similar terms. When contracting for

4 Contract completeness is the degree to which these elements are contractually specified, most importantly by defining task, outcomes, and compensation as the basic terms of exchange. These core elements structure the degree to which the contract is complete. Around these core elements, contracts can also be more or less complete based on the nature of the governance features that specify how the exchange will take place and how the parties will interact in the course of delivering the service (Brown, Potoski, Van Slyke, 2008).

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simple products, buyers and sellers can be reasonably confident of achieving the mutual gains

from successful win-win market exchanges.

Rosy win-win scenarios are less likely in contracting for complex products where neither

buyers nor sellers know the products’ cost, quality and quantity parameters ahead of negotiation

and production.5 Complex products are exchanged under incomplete contracts because

uncertainty is so high that the costs of writing out all contract terms to account for all future

scenarios exceed the mutual gains from the trade and no contracting would occur. The

consequence of an incomplete contract is that an uncertain future can create ambiguities about

roles and responsibilities and produce circumstances that favor one party at the expense of the

other. Consequently, the costs of contracting include the risks of renegotiations and of being

held to contract obligations that unforeseen circumstances have made unfavorable. These

unforeseen circumstances, what we call nature, can fundamentally change the payoffs for

producing, exchanging and consuming a product, making it more valuable to the buyer, raising

its production costs, and so on.

Parties to complex contracts can work ex ante to reduce uncertainty so the contract can be

more specific, such as investing in research and development, or write a less specific contract

expecting to renegotiate ambiguities ex post as the product is produced and the exchange

executed. Such investments are asset specific to the extent they can not be put to alternative use.

In an exchange with asset specific investments, incomplete contracts coupled with uncertainty

about the future raise the specter of the classic hold-up problem (e.g. Williamson, 1996). From

the buyer’s perspective, the risk of making an asset specific investment is that once the

investment has been made, there is no alternative seller for the product, which means the seller

5 A lot has been written about lemons markets where buyers are uncertain about the product but sellers are not (Akerloff 1970). In this paper, we focus on contracts where buyers and sellers each are initially both uncertain.

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can exploit contract ambiguities to “hold up” the buyer to extract more favorable terms, even

terms that the buyer would not have agreed to with foreknowledge. This fear is complicated by

the fact that for many complex goods and services, government is the only buyer (e.g. weapons

systems); once the buyer makes a decision about a particular product or solution the market

clears as other potential sellers have no purchasers for their proposed product or solution. The

seller faces a similar dilemma in that they devote significant resources to develop (and perhaps

design) a specific solution for the buyer and face the uncertainty that at some point in the future

the buyer may walk away from the contract for any number of reasons (e.g. the product doesn’t

successfully address the buyer’s needs, authorizers prohibit the buyer from continuing with the

procurement).

Incomplete contracts for complex products are also vulnerable to the vagaries of an

uncertain future: unforeseen circumstances may leave either party trapped in a contract it would

not have entered had it known what was to come. Producing the product reduces uncertainty as

sellers, and perhaps to a lesser extent buyers, learn about the product and its quality-cost

tradeoffs. Such learning can be captured as lower production costs and scale economies if the

contract is for multiple products of the same type. It is important to note that the fruits of

reduced uncertainty are not necessarily enjoyed equally by buyers and sellers. For example,

governments may realize that the delivered service does not meet what is needed or vendors’

production costs may turn out to be much higher than anticipated, with the government enjoying

cost savings and the vendor suffering losses. Incomplete foreknowledge also means that either

side may find itself in a position to exploit unforeseen circumstances for its own advantage. A

seller, for example, may exploit contract ambiguities to lower service quality because the

contract may lack provisions for the buyer to enforce original terms. In the absence of clear and

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specific tasks, outputs, or outcome terms, the seller may misrepresent the quality of its “product”.

On the other hand, the buyer, because it may have delivered the service directly in the past, may

have more information about the challenges the seller is likely to face as it delivers the service.

The buyer can use this first-hand knowledge opportunistically to negotiate a contract that fails to

specify the known conditions under which the seller can claim compensation for costs.

All in all, we can see that achieving win-win outcomes in more difficult in contracting for

complex products. Complex contracting’s success is a function of managing the uncertainty

associated with both the behavior of the other party and the unexpected impacts of exogenous

natural factors. Ex ante, both parties to the exchange can take a variety of steps to promote

positive cooperation, such as signaling cooperation and concern about future contracting,

revealing information about production and profits, and so on. As nature reduces uncertainty,

buyers and sellers can renegotiate contract terms, adjusting the existing contract midstream or

writing new terms for future transactions. This assumes, however, that the buyer and/or the seller

can identify nature’s impact on contracting’s outcomes. Both parties may have the advantage of

more information than when they entered into the initial agreement, but perhaps not sufficient

information to discern the causes of the outcome they and the other party received. The relative

level of information at this ex post phase highlights the accountability challenges of contracting

for complex products. In the next section we turn to game theory as a tool to help analyze the

contracting process as it unfolds from the ex ante to ex post stage.

The Contracting Game

Contracting can be viewed as a bilateral game between a buyer and a seller. For each

party, the risks and rewards, or payoffs, of a contract reflect the contract’s design (i.e. each

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parties’ responsibilities), the behavior of each player relative to the behavior of the other player

(i.e. the players’ “moves”), and exogenous factors (i.e. nature). Payoffs reflect the objectives of

each player; buyers seek to optimize across cost and quality (inclusive of timeliness), while

sellers seek to maximize profits. Treating contracting as a simple bilateral game provides a

powerful heuristic for examining the possibility of a win-win outcome for complex contracting,

as well as for identifying key accountability issues. In this section we present a basic contracting

game with four discrete phases described below.

In the first phase of the contracting game, the buyer and seller negotiate contract terms

and decide whether to make any asset specific investments to produce the good or service (e.g.

research and development). Higher asset specific investments mean higher hold up risks; lower

investments mean a less precise contract and a higher risk of renegotiation costs in the future. In

the contracting game’s second phase, the buyer and seller simultaneously decide and execute the

approach they intend to take in fulfilling their responsibilities – however clearly or unclearly

defined – in implementing the contract. A party that chooses to “cooperate” executes her

contract obligations with the goal of maximizing win-win gains for both sides, even if she could

have done better (and her partner done worse) through another strategy. Alternatively, a party

that chooses to “defect” makes minimal investments in achieving a win-win gain for both sides,

and perhaps pursues a strategy of ensuring a win for herself even if it results in a loss for the

other party. In the third phase, “nature” reveals itself as positive or negative exogenous factors

that affect the product’s costs and qualities. In the fourth phase players’ strategies combine with

nature to determine payoffs (e.g. win, win). At this point, buyer and seller enjoy more

information than at the outset and hence have the opportunity to renegotiate contract terms ,

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leave the contract in place, or exit the contract.6 Figure 1 models the game’s four phases

graphically.7

[INSERT FIGURE 1 HERE]

In a classic prisoner’s dilemma game each player improves his own position by defecting,

no matter what the other player’s strategy, even though mutual defection leaves the two players

worse off than cooperation.8 Assuming a one shot purchase, we can see how contracts for

complex products mirror the basic prisoner’s dilemma game. Each party may find itself

strategically advantaged in the contract to the extent the other side has made asset specific

investments and the extent to which unforeseen circumstances allow it to exploit contract

ambiguities for its own gains and at the other side’s expense. A seller, for example, might find

himself with the opportunity to “gold plate” the product by adding costly features that increase

his profits but add little value and considerable expense for the buyer. Likewise, a buyer may

force a seller to produce an expensive product even with knowledge that a much cheaper product

would meet her needs almost as well. The problem in these cases is that the winners’ gains are

smaller than the losers’ losses. In other words, the winner’s choice gives him a larger share of a

smaller pie. Alternatively, the winner could make decisions to maximize her own gains only

when the gains are larger than the other side’s losses, and may even take on losses for herself if it

means larger gains for her partner.

6 In the event that the contract is finished at this point, but the buyer still demands more of the product, the alternatives are to draft a more complete contract for new purchases, utilize the same incomplete contract again, or forgo the exchange. 7 Note that in the second column even though the buyer’s decision to cooperate or defect is presented first, buyer and seller make their strategy decision simultaneously without knowledge of the strategy decision of the other party. 8 An appendix displays the basic payoff matrix of a simple prisoner’s dilemma game.

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After parties have selected their contract strategy and begun to execute the contract,

nature intervenes to affect the payoffs parties receive. The affect of nature is random in the sense

that the parties did not know the probabilities or events that could occur. Perhaps it turns out that

the product is cheaper to produce than anticipated. Or perhaps the buyer learns that the product

will be even more valuable than she had anticipated. Nature can affect buyers and sellers, but

buyers and sellers do not necessarily know how nature affected them or the other party. For

example, if a seller easily solves a problem thought to have been difficult was it because of luck

or because the problem was easier to solve than anticipated?

Payoffs in the contract are determined by the buyer’s and seller’s combined strategy

choices, and the fortune nature has brought them. The parties’ strategic choices affect payoffs in

the manner proscribed by the prisoners’ dilemma: the combined payoffs are highest if both

pursue cooperative strategies, although each can do better by defecting when the other

cooperates. If both defect, the combined payoffs are lowest. In our version of the complex

contracting game, each player knows their own payoff from the game, but not the other’s, and

neither player knows why the payoffs turned out as they did. The problem is that the other

player’s strategy, payoffs and contribution of nature all occur under the shroud of uncertainty.

Figure 2 depicts the second through fourth phases of the contracting game – strategy

selection, the impact of nature, and payoffs. The figure maps the prisoner’s dilemma strategies

and payoffs with the outcome of nature in a simple tree-form of the game. When the buyer and

seller both cooperate, the payoffs are three for each, and when they both defect, the payoffs are

two. If one cooperates and the other defects, the cooperator receives one and the defector

receives four. Figure 2 depicts the effect of nature as a plus or minus two, which to simplify our

illustration we show affecting equally buyer and seller payoffs. There are more complex and

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realistic ways of depicting nature’s role in this game; nature’s payoff can be more variable, such

as by favoring one party while harming another, and by different amounts. We keep Figure 2

simple to convey the model’s underlying logic.

In the most favorable scenario in Figure 2, both the buyer and seller choose a cooperative

strategy and nature provides favorable conditions, giving each side a payoff of five: three each

from mutual cooperation plus nature’s positive contribution of two to each. Had nature not been

so fortunate, the payoff would have been lower, perhaps three or less for the buyer and seller had

nature’s contribution been zero or a negative value. If the buyer chose to cooperate and the seller

chose to defect, the buyer’s payoff would be lower – in Figure 2 it would be only one exclusive

of nature’s combination. If in this scenario nature’s contribution is positive, the buyer could end

up with a payoff that is higher than she would have received under a mutual cooperation scenario

with a negative nature payoff.

This theoretical depiction of complex contracting raises fundamental issues for

accountability in public sector procurement. The buyer only knows her own contract strategy

and her own payoff; the seller’s strategy and payoff, and nature’s contribution are all unknown to

the buyer. Consequently, the buyer can not discern the extent to which the payoff she receives

results from the interaction between her strategy with the seller’s or from nature’s fortune.

Consider further the case of a buyer who has chosen a cooperative strategy: a moderate payoff

for the buyer may be the result of a cooperative seller strategy coupled with a penalty from

nature, or may be the result of fortunate natural circumstances coupled with the buyer choosing a

defect strategy. Such uncertainty is pervasive to the extent the buyer does not know nature’s

contribution to the payoffs or the buyer’s strategy.

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Illustration: Accountability Challenges in the Coast Guard’s Project Deepwater

In this section we present an example – the Coast Guard’s Project Deepwater – to

illustrate the accountability challenges inherent in contracting for complex contracts. We use the

basic logic from the contracting game described above to highlight the challenges of complex

contracts. Negotiations occurred in a context of high uncertainty and fear of lock-in. The

resulting contract was incomplete. The Coast Guard and the selected vendor both proclaimed

they were choosing cooperative contracting strategies, although these claims are difficult to

verify. The contract’s initial payoffs were lower than anticipated for both the buyer and seller,

although it is difficult to determine whether this was the result of contract strategies or an

environment that turned out to be less favorable than anticipated. We conclude this section by

highlighting the accountability challenges faced by the Coast Guard and its political overseers as

the Deepwater procurement moves forward.9

Project Deepwater Background

In recent history the Coast Guard’s procurement practice was to separate purchases for

individual classes of vehicular assets – ships, cutters, planes and helicopters; when a class of

ships was no longer sea worthy, the Coast Guard bought a new one to replace it, perhaps with a

modified design better suited to the Coast Guard’s evolving mission.10 Because it bought fewer

and smaller assets relative to other major naval buyers – notably the U.S. Navy – the Coast

Guard largely made ad hoc purchases from a handful of small sellers (e.g. regional shipyards

9 This section is based on a series of interviews with participants involved in Project Deepwater along with testimony, oversight reports, and publicly available material produced by the vendor and the Coast Guard. The Deepwater Program acquisition is continuing. At this stage we highlight early accountability challenges. 10 The Coast Guard’s mission is that of a law enforcement and military organization and it is engaged in maritime security (upholding the law), maritime safety (rescuing the distressed), the protection of natural resources (protecting the environment), maritime mobility (ensuring safe marine transportation), and national defense (operating in coordination with the U.S. Navy).

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such as Bollinger). Without significant procurement experience or capacity, and purchasing only

infrequently and for small quantities, the Coast Guard sometimes even acquired assets as part of

larger U.S. Navy procurements.

By the early 1990s it became clear that the Coast Guard needed a more targeted and

strategic approach to upgrade its rapidly aging asset fleets.11 Many of the Coast Guard’s assets

were reaching the end of their usable life-span and were not ideally suited to the modern Coast

Guard’s missions. In response, the Coast Guard leadership lobbied for a long-term acquisition

strategy that would upgrade and modernize the entire Coast Guard fleet. The Coast Guard’s goal

was to acquire a system of interoperable assets whose seamless communication and coordination

would make the efficacy of the whole greater than the sum of its parts. In 1998, Congress and

the Clinton administration committed to a multi-year procurement at $500 million a year,

significantly more than the Coast Guard’s historical acquisition expenditure.12 The result was the

Deepwater program or Project Deepwater.

The Coast Guard essentially sought a complex product for its Deepwater upgrade. The

Coast Guard and prospective sellers faced high levels of internal and external uncertainty. In

terms of internal uncertainty, the challenge was to design and build an array of sophisticated

interoperable assets – that is they all had to be able to communicate with each other and

seamlessly coordinate their activity in pursuit of different targets (e.g. armed speedboats running

contraband, sailors lost at sea, make-shift vessels porting illegal aliens) – with a hard cap on

overall costs (i.e. $500 million a year). The seller also had have the production capacity or

purchasing ability to deliver very different kinds of assets: ships, cutters, helicopters and planes.

11 As of 2001, eight-six percent of the Coast Guard’s assets, deepwater and air, had reached or were expected to reach the end of their planned service life within five years. The Coast Guard’s fleet of assets was widely considered to be one of the oldest in the world, ranking 37 out of 39 of the fleets worldwide (Acquisition Solutions, 2001, p.6). 12 http://govinfo.library.unt.edu/npr/library/news/062999.html

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In terms of external uncertainty, the distributed global reach of the Coast Guard meant

that the environmental conditions and operational missions varied dramatically from location to

location. Coast Guard ice breakers in the Bering Strait needed ships that could do different

things than Coast Guard personnel responsible for drug interdiction in the waters off Florida. In

addition, while Coast Guard had secured the commitment of one administration and the sitting

Congress to a $500 million-a-year procurement budget, there was no guarantee that subsequent

administrations and Congresses would adhere to that pledge.

The combination of interoperability, dual aerial and naval production capacity, varying

environmental and mission requirements, and tenuous political commitments translated into an

asset specific buy with a significant risk of lock-in. To meet the Coast Guard’s request the seller

would have to make high up-front investments to design and build a product to meet the specific

needs of a single client with the real possibility that the client may be forced to walk away from

the commitment at a later date. The seller would then be left with a product, and perhaps a

production process, for which there were few, if any, other buyers. For the Coast Guard the risk

was that the seller that won the bid would eventually gain an information advantage over the

Coast Guard as it began to design and build the product. At the same time, absent any other

buyers of similar products, the market would clear. If things went wrong with the selected seller

(e.g. the seller began to “gold plate” the product), the Coast Guard would have limited options on

where to go to acquire alternative aerial and naval production capacity and systems engineering

expertise.

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Contract Negotiation

In 1998, the Coast Guard issued an RFP describing the mission needs and performance

goals it sought for its upgraded fleet, including the interoperability of its assets, and inviting

industry to propose creative solutions. The Coast Guard evaluated the three industry proposals it

received based on the degree to which they met mission requirements, lowered total ownership

costs, and, to minimize risk, relied on proven, off-the-shelf technologies. The Coast Guard

selected Integrated Coast Guard Systems’ (ICGS, a consortium between Lockheed Martin and

Northrop Grumman) proposal to upgrade or replace ten new asset classes of air and sea vessels

by 2027.13 Under the ICGS proposal, the modernized Deepwater Coast Guard force would not

only be technologically advanced, but each asset in the system would also be fully integrated in a

state-of-the-art command, control, communications, computers and intelligence, surveillance,

and reconnaissance system commonly referred to as C4ISR.

In June 2002, the Coast Guard awarded to ICGS an initial contract for designing,

building, integrating, and testing the assets in the system. At this early stage, most of the work

was for system and asset design and testing, including specifying performance standards for the

system and each of the planned assets. Under the contract terms, ICGS had full technical

responsibility for designing and constructing all Deepwater assets, and for deciding whether

contract components should be put out for competitive bids in second tier contracts.

Given the uncertainty faced by both the Coast Guard and ICGS in producing a complex

product, or system of products in this case, the two parties entered into an incomplete contract to

govern the exchange – a performance-based indefinite delivery, indefinite quantity (IDIQ)

contract. In the simplest terms, an IDIQ does not specify a firm quantity of products or the tasks

13 ICGS proposal included five new sea vessels, two fixed-wing aircraft, two helicopters, and one unmanned aerial vehicle. The other assets were upgrades.

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required to produce them. Instead, it must either specify a minimum or a maximum number of

products and some end-point for termination of the agreement.14 The Coast Guard and ICGS

agreed to an initial IDIQ contract for five years, renewable in five year increments for a total of

twenty-five years. Within this contract architecture, ICGS and the Coast Guard agreed to

negotiate individual task orders for specific work to be performed (e.g. designing, building and

testing three National Security Cutters, the largest class of ships in the Coast Guard fleet). The

contract specified broad goals in the form of the general assets categories, the performance

specifications for the assets, and a ceiling on the number of assets within each class. It did not

specify a minimum number of assets (a floor) or the actual design specifications of the assets.

The latter was to be worked out through a variety of governance mechanisms, notably individual

task orders and Integrated Project Teams (IPT) for each of the asset acquisitions. The IPTs were

collaborative governance mechanisms that brought together ICGS personnel, relevant

subcontractors, and Coast Guard officials to negotiate and decide which technologies would be

used to meet overall mission requirements. In short, it created vehicles and venues for

negotiation and renegotiation, but did not specify the rolls, responsibilities and authorities of

various actors in these processes.

Strategy Selection, Nature and Payoffs

With the IDIQ contract architecture, the individually negotiated task orders, and the IPTs

to govern the details of the design and production process, both ICGS and the Coast Guard

claimed that they had cemented a “partnership” rather than entering into an arms length

14 See e.g. FAR Subpart 16.5 – Indefinite-Delivery Contracts (http://www.arnet.gov/far/current/html/Subpart%2016_5.html#wp1093133)

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transactional relationship. At they outset, they signaled to each other that they would

“cooperate” in game theory terms.

At this point unexpected external forces changed the dynamic of Project Deepwater. The

terrorist attacks of September 11, 2001 spurred the assignment of the Coast Guard to the newly

created Department of Homeland Security (DHS). This added new mission requirements to the

Coast Guard’s already extensive panoply of missions; the Coast Guard was now responsible for

collaborating with other government agencies to help prevent future terrorist attacks on U.S. soil.

Not only did Coast Guard’s assignment to DHS create mission strain, but it also increased Coast

Guard’s “operational tempo”, or the speed at which Coast Guard had to prepare and conduct its

tasks and functions. 15 In response to these external events, Coast Guard acquisition personnel

made significant changes to the overall Deepwater program, both by adding new assets and

changing some of the performance requirements for planned asset acquisitions. For example,

post 9/11 the National Security Cutter class of surface assets had to be able to withstand a

nuclear, biological, and chemical attack, a non-trivial change.

Perhaps operating under the assumption that in their “partnership” with ICGS these

changes could be made easily, Coast Guard elected not to engage ICGS in their discussions

about modifying the Deepwater program. This was most apparent in the IPT meetings where

ICGS personnel chaired and ran the coordinating and planning decision making process, and

Coast Guard personnel in attendance did not actively participate.16 Ultimately, Coast Guard

acquisition personnel simply delivered ICGS a new scope of work. ICGS agreed to make the

additions and changes, but indicated that production time-lines would lengthen and that there

15 US GAO Testimony: “Homeland Security – Challenges Facing the Coast Guard as it Transitions to the New Department”, February 2003. GAO-03-467T 16 US GAO Testimony: “Coast Guard – Preliminary Observations on the Condition of Deepwater Legacy Assets and Acquisition Management Challenges”, June 2005. GAO-05-651T

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would be additional costs. Faced with an increased “operational tempo” and new mission

requirements, Coast Guard had little choice but to agree. The “partnership” arrangement

transformed quickly into a transactional arrangement with ICGS billing Coast Guard for every

change or modification to the existing agreement, and considerable confusion about what ICGS

had agreed to produce.

One of the best examples of the failed promise of “partnership” was the 123-foot cutter,

one of the first assets to be delivered. Prior to 9/11 the Coast Guard had planned to acquire a

new fleet of fast response cutters to be delivered by 2018. After 9/11, the Coast Guard elected to

modify its existing 110-foot cutter, primarily by adding 13 feet of deck and hull. The new task

order with ICGS called for all 49 existing cutters to be modified. The production and delivery of

these assets quickly became plagued by a series of problems. For one, Coast Guard agreed to an

ICGS proposal to develop a composite hull, a novel, but untested approach to retrofitting the

boat. Soon after the delivery of the first eight 123-foot cutters, testing and review of the patrol

boat’s structure revealed hull buckling, potentially compromising the viability of the asset. In

addition, the Coast Guard identified 22 of the 110-foot cutters that, due to unexpectedly severe

hull corrosion, required additional inspection and repair separate from the Deepwater

modification plans. Further, Coast Guard officials had four cutters in operation in the Persian

Gulf, which made them unavailable for modification.17 Both sides expressed confusion about

the status of the cutter modifications, the hull repair program, and the overall schedule. By 2006,

the Coast Guard decided to dry-dock the 123-foot cutters, decommissioning them from the Coast

Guard fleet.18

17 US GAO Report. March 2004. “Contract Management: Coast Guard’s Deepwater Program Needs Increased Attention to Management and Contractor Oversight”. GAO-04-380 18 U.S. Coast Guard Press Release. Nov. 30, 2006. “Coast Guard Suspends Converted Patrol Boat Operations”. http://www.piersystem.com/go/doc/786/138897/

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Both sides got less than anticipated from the first five-year installment of the IDIQ

contract. The Coast Guard faced program delays, higher costs, and received a non-operational

asset. The overall acquisition schedule lengthened from 25 to 30 years and the planned

acquisition costs jumped from $17 billion to $24 billion.19 ICGS faced unexpected renegotiation

costs due to repeated changes to the original agreement, and the reputations of both Northrup

Grumman and Lockheed Martin suffered as a result of perceived poor performance. The

promise of a win, win “partnership” deteriorated into a lose, lose transaction.

What explains this outcome? Some evidence points to the behavior of the Coast Guard –

repeated major changes to task orders and a failure to claim a role in the IPTs. Other evidence

points to the behavior of ICGS – the performance test failure of the composite hull on the 123-

foot cutters and its dominance of the IPTs. Finally, some evidence points to unexpected external

events – 9/11 and its aftermath. In response, both parties lack trust in the other and fear

“defection” moving forward, although neither party is able to determine whether current

outcomes are a result of the strategy and behavior of the other party or exogenous forces outside

either party’s control. Now other forces are at work, most notably more aggressive scrutiny from

an array of overseers (e.g. DHS’s Inspector General, the Government Accountability Office, the

Congressional Research Service). A changeover from a Republican to Democratic majority in

2004 has intensified oversight; Congressional Democrats are particularly incensed by what they

perceive to be mismanagement by both parties, and as a result have pushed the Coast Guard

away from a reliance on ICGS as a systems integrator. At the moment, the Coast Guard is in the

process of standing up its own system engineering and acquisition capacity for Project

Deepwater in an internal entity called the Acquisition Directorate. The Coast Guard remains

19 US GAO Report. April 2006. “Coast Guard: Changes to Deepwater Plan Appear Sound, and Program Management Has Improved, but Continued Monitoring is Warranted.” GAO-06-546.

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“locked in” with Lockheed Martin and Northrup Grumman to some extent, but they are moving

away from their integrated partnership back towards a piece-by-piece acquisition approach.

Conclusion

The game theory model and illustration of the Coast Guard’s Project Deepwater we

presented so far suggests complex contracting is a dire endeavor. Complex contracts are highly

uncertain, costly to negotiate and execute, and obfuscate accountability. Under the prisoners’

dilemma, win-win cooperation is irrational and lose-lose outcomes most likely. Uncertainty

about nature’s contributions to payoffs mean even the parties in the contract do not know

whether contract outcomes stem from misfortune, the other party’s malfeasance, or their own

mismanagement. In the case of Deepwater the default response of both Coast Guard and ICGS

is to assume that the other player “defected”. Overseers, notably Congressional oversight

committees, have made a similar determination and have taken steps to push Coast Guard into a

“defect” strategy in future rounds. As our analysis shows though, while there’s evidence to

suggest that one or both of the exchange parties are partially at fault, nature played a strong hand

in either producing the negative outcomes or pushing the exchange parties towards a lose, lose

outcome. In moving forward, the default response shouldn’t necessarily be to position Coast

Guard and whatever sellers it engages into a rigid defect, defect posture almost.

Because complex contracts are prone to renegotiation, the “shadow of the future” opens a

wealth of cooperative strategies, allowing contract parties to turn lose-lose conflict into win-win

cooperation (e.g. Heide and Miner, 1992). Moreover, these cooperative strategies enhance

overseer’s ability to hold people accountable in the contract process. In the case of Project

Deepwater, the multi-stage architecture of the contracting process allows for this kind of

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renegotiation. While the projection is that it will take 30 years to deliver all the component

Deepwater assets, the Coast Guard and ICGS did not formally commit to a 30-year agreement.

Instead the contract is structured in five year increments. The asset specific nature of the

products means that the Coast Guard faces a thin market of alternative suppliers, but at a

minimum the overall contract arrangement allows for both exit and renegotiation. The shadow

of the future is real here, and there are significant consequences to both parties in terms of costs

and reputation from spiraling away from a partnership arrangement towards a more antagonistic

arms length transactional relationship. In addition, Congress’ increasing oversight and

involvement in the Deepwater program demonstrate how authorizers can take steps to change the

rules of the game. At present, Congress is pushing the Coast Guard towards more of a prisoner’s

dilemma game, away from a cooperative game, but it doesn’t have to be so. Congress could

instead take steps to foster cooperation albeit while increasing the level of information available

to all parties to insure accountability. For example, rather than forcing Coast Guard to move

away from an integrated relationship with ICGS to a more differentiated purchasing

arrangement, Congress instead encourage Coast Guard could build on recent efforts to enhance

Coast Guard’s role in the IPTs and rely more extensively on third party certification of product

design and delivery. One of the primary reasons to take such steps is that there are significant

opportunities to capture knowledge and information from the first round and apply it to

subsequent rounds of contracting. The practice of complex contracting need not be so dire.

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References Akerloff, G. (1970). The Market for Lemons: Qualitative Uncertainty and the Market Mechanism. Quarterly Journal of Economics, 84(3): 488. Bajari, P., and Tadelis, S. (2001). Incentives versus transaction costs: A theory of procurement contracts. Rand Journal of Economics, 32(3):387-407. Brown, T., Potoski, M., and Van Slyke, D. (2008). Trust and Contract Completeness in the Public Sector. Local Government Studies, 33 (4): 607-623. David, P.A. (1985). Clio and the Economics of QWERTY. The American Economic Review, 75 (2): 332-337. Heide, J., and Miner, A. (1992). The Shadow of the Future: Effects of Anticipated Interaction and Frequency of Contact on Buyer-Seller Cooperation. Academy of Management Journal 35 (3): 265-291 Heinrich, C.J. (1999). Do government bureaucrats make effective use of performance management information? Journal of Public Administration Research and Theory, 9(3):363-394. Hutton, J. (2008). Presentation on Contracting to MPA students, Maxwell School of Citizenship and Public Affairs, April 2. Data based on GAP Analysis of data from the Federal Procurement Data System. Kelman, S.J. (2002). Contracting. In Salamon, Lester M., The tools of government: A guide to the new governance. New York, NY: Oxford University Press. Martin, L.L. (2004). Performance-based contracting for human services: Does it work? Administration in Social Work 29 (1): 63–77. O’Looney, J.A. (1998). Outsourcing state and local government services: Decision-making strategies and management methods (Westport, CT: Quorum Books). Sclar, E.D. (2000). You don’t always get what you pay for: The economics of privatization. Ithaca, NY: Cornell University Press. Weimer, D., and Vining, A. (1999). Policy Analysis: Concepts and Practice (Upper Saddle River, NJ: Prentice Hall).

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Williamson, O. (1996). The Mechanisms of Governance. New York: Oxford University Press.

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Figure 1: The Contracting Game

Phase I:

Negotiation

Phase II:

Strategy Selection

Phase III:

Nature

Phase IV:

Payoffs

Buyer Seller

Positive (#, #)

Cooperate

Negative (#, #)

Cooperate

Positive (#, #)

Defect

Negative (#, #)

Incomplete

Contract

Positive (#, #)

Cooperate

Negative (#, #)

Defect

Positive (#, #)

Defect

Negative (#, #)

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Figure 2: The Impact of Nature

Phase II: Strategy Selection

Phase III: Nature

Phase IV: Payoffs

Buyer Seller Buyer Seller Mutual Gain

Positive 3 + 2 = 5 3 + 2 = 5 10

Cooperate

Negative 3 + -2 = 1 3 + -2 = 1 2

Cooperate

Positive 1 + 2 = 3 4 + 2 = 6 9

Defect

Negative 1 + -2 = -1 4 + -2 = 2 1

Positive 4 + 2 = 6 1 + 2 = 3 9

Cooperate

Negative 4 + -2 = 2 1 + -2 = -1 1

Defect

Positive 2 + 2 = 4 2 + 2 = 4 8

Defect

Negative 2 + -2 = 0 2 + -2 = 0 0

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Appendix I: The Basic Prisoner’s Dilemma Game Buyer Strategy Cooperate Defect

Seller Strategy

Cooperate

3, 3

1, 4

Defect

4, 1

2, 2