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On the study of the impact of relaxing the pre-qualification requirements on the competitiveness in the supply of water pumps
ARTICLE IN PRESS
Building and Environment 40 (2005) 213–219 www.elsevier.com/locate/buildenv
On the study of the impact of relaxing the pre-qualification requirements on the competitiveness in the supply of water pumps C.K. Chau, W.L. Lee, J. Burnett, M.Y. Law, T.M. Leung Department of Building Services Engineering,The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong, SAR Received 4 February 2004; received in revised form 1 July 2004; accepted 13 July 2004
Abstract This paper reports a pioneering and quantitative approach being developed for assisting a large-scale high-rise residential building developer in Hong Kong in monitoring the competitiveness in the supply of fresh and flush water pumps to the building development projects. Integrated empirical pricing models based upon the hedonic price technique have been developed for the supply of both fresh and flush water pumps to the developer and the competitive sector. Our results revealed that the pricing levels charged to the developer were comparable to the competitive sector even though the quality standards of water pumps delivered were much lower. Upon close examination of the market structure, it was found that this was possibly due to the Limit Pricing Strategy being adopted by two leading suppliers in the developer’s market as a result of relaxing the pre-qualification to standards below the industry norm. This finding should add to our understanding on the impact on the market competitiveness due to relaxation of pre-qualification requirements. Besides, measures of enhancing competitiveness in the supply market have also been discussed. r 2004 Elsevier Ltd. All rights reserved. Keywords: Pre-qualification; Competitiveness; Specification; Mechanical equipment in buildings
1. Introduction This paper investigates the effect on market competitiveness as a result of a strategy of laying down less stringent and less specific pre-qualification requirements for the supply of flush and fresh water pumps to a largescale high-rise residential building developer in Hong Kong. This paper reports on the findings of a consultancy study on whether comparable market prices were being charged by monitoring the pricing levels of flush and fresh water pumps supplied to the developer, reviewing the market structure as well as relevant specification standards. It is expected that the findings should add to our understanding on the issue whether greater degree of competitiveness can be Corresponding author. Tel.: +852-2766-7780; fax: +852-2774-6146. E-mail address: [email protected] (C.K. Chau).
0360-1323/$ - see front matter r 2004 Elsevier Ltd. All rights reserved. doi:10.1016/j.buildenv.2004.07.006
enhanced by reducing the stringency of the prequalification requirements.
2. Background Pre-qualification requirements are generally employed by the clients in the construction industry to identify a group of qualified market players so as to minimize the efforts of the project teams, improve the operation efficiency of the vetting procedures [1], and maximize the probability of obtaining a quality product [2]. More specifically, pre-qualification requirements define the minimum quality threshold before any market players are allowed to be included in the pre-qualification list and to tender for material supply or construction contracts. However, the imposition of pre-qualification requirements of any forms will restrict the degree of competition in the existing supply market. With more
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stringent pre-qualification requirement imposed, fewer market players are able to meet the requirements. The smaller the number of qualified market players, the greater possibilities of having high prices charged [3–6]. In cases where the market is dominated by a small group of market players, some forms of oligopoly or even collusive practice will be developed in the market. This will likely result in unreasonably increase in the prices charged [7,8]. On the other hand, relaxing the prequalification requirement is always perceived to be an effective strategy for resolving the issue of inadequate competitiveness [9]. Generally, relaxation of pre-qualification requirements can lead to an increase in the number of qualified market players, and presumably also an increase in the market competitiveness. The findings from some studies reinforced this proposition that the degree of competition would become more intense with the relaxation of the pre-qualification requirements. Our previous study also revealed that the price of switchboards would become more competitive as a result of relaxing the stringent pre-qualification requirements so as to in line with the industry norms on both product quality and quality surveillance requirements [10]. However, market competitiveness may not always be increased since there is not a wellproven direct relationship between the number of qualified market players and the degree of market competitiveness. Accordingly, this study intends to bridge this gap by focusing on the effect on the market competitiveness due to the relaxation of the pre-qualification requirements through a detailed examination on the market supply of fresh and flush water pumps to the developer. Nevertheless, this issue cannot be successfully addressed without first developing a logical, scientific and yet practical protocol for evaluating the competitiveness of supply in the fresh and flush water pumps. Even though there was a similar protocol being developed for evaluating the price competitiveness of the low-voltage switchboards supplied to the developer [10], the key price indicator used was only derived from the rule of thumb adopted by the industry. This paper intends to overcome this shortcoming by developing a practical protocol with the aid of appropriate theoretical econometric models. The final models would be formulated by identifying a practical way of acquiring reliable and sensitive cost data; and addressing the special characteristics of fresh and flush water pumps, and the building industries.
3. Methodology Our fundamental interest in this study was to reveal whether the imposition of relaxed pre-qualification requirements by a large-scale housing developer in
Hong Kong on the fresh and flush water pumps could lead to a reasonable degree of competitiveness in their supplies. However, this issue cannot be easily addressed without clearly defining what competitiveness is. Unfortunately, up to date, competitiveness does not have a unanimous definition and it may even have different meanings in different context [11]. As the concept of competitiveness is considered to be context dependent, its measurement should reflect the type of competitive environment investigated. In construction projects, the degrees of competitiveness are commonly measured by the closeness in the bid values being put forward by tenderers [12]. The closer the bid values being put forward by the tenderers, the more competitive the market supply will be. However, this can only be applicable on individual project or tender levels as competitive in individual tender levels may not necessarily imply that they are also competitive in the broad industry levels. Given that the objective of this study is to reveal the competitiveness of market supply to the developer, competitiveness in the following context is measured by how comparable in the pricing levels being charged to the developer and the clients in the competitive market sector. In order to monitor the degree of competitiveness in pricing levels of fresh and flush water pumps supplied to the developer, empirical pricing models based upon the hedonic price technique have been developed for the supply of each type of water pumps to the developer and the clients in the competitive market sector. Hedonic price technique rests on the hypothesis that a consumer when consuming a particular commodity is consuming the different characteristics of the commodity. Specifically, the technique is based on a regression analysis of the price on the characteristics (attributes) of the commodity with an objective of revealing the implicit prices a consumer places on additional unit of characteristic for a particular commodity [13–16]. Theoretically, the implicit prices for different attributes of a commodity could be computed, so that comparison on pricing levels could subsequently be made on an equivalent quality standard [17,18]. In this study, regression analysis was conducted using the unit pricing rates of the fresh and flush water pumps, and their product characteristics as dependent and independent variables, respectively. The unit pricing rates for fresh and flush water pumps were extracted from the schedules of rates, which were a notional breakdown of work items and their associated pricing for individual projects, from the successful tenderers for individual projects. Apart from unit rates, design details of the fresh and flush water pumps, such as volumetric flow rates and total pressure heads, were extracted from the tender drawings of individual projects. Types of materials used for construction of casings for pumps, and other special requirements on design, construction
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and quality assurance were extracted from the specification standards associated with the project. All the required information was extracted from both the residential projects from the developer’s and the competitive market with tendering-in dates falling between January 1, 1998 and March 31, 2001. As a result, information was collected from 67 residential projects from the developer, and 30 residential projects from the competitive market, which was formulated by a wide spectrum of large-scale developers in Hong Kong.
4. Results and analysis 4.1. Competitiveness on the pricing levels of water pumps supply to developer Intuitively, simple statistical t-tests could be used for comparing the mean pricing levels charged to the developer and the clients in the competitive market sector. However, such type of comparison method was only considered to be appropriate if the characteristics and standards of water pumps used by the developer and the clients in the competitive market sector were identical. However, there were substantial differences on the operating characteristics of water pumps being adopted by the developer and the clients in the competitive market sector. The types of water pumps adopted by the developer were generally having larger volumetric flow rates since the housing estates constructed by the developer had more apartment units and higher occupant densities per floor. Given that the operating characteristics of water pumps used within these two sectors were different, they should be treated as heterogeneous products in our analysis. Hedonic price models were used in this study for describing the prices of fresh and flush water pumps in terms of their operating characteristics. As mentioned previously, they were developed by regressing the pricing levels of the water pumps on their operating characteristics so as to determine the implicit prices a consumer places on additional units of these operating characteristics. However, neither economic theory nor earlier researches in this field does prescribe any specific functional form that should be adopted for these types of regression models. Without a practical guidance, the adoption of empirical estimation of hedonic price requires a careful choice of functional form [19,20]. In this study, log-linear forms were chosen in this study for representing the prices of both fresh and flush water pumps since they were more plausible and they produced reasonable coefficients of determination. Specifically, the log of prices of fresh and flush water pumps were individually regressed against both the
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corresponding volumetric flow rates (V) and the pressure heads (H). In order to examine the issue on whether the pricing levels were comparable within these two different market sectors, fully integrated hedonic pricing models have been constructed for both fresh and flush water pumps. The models were developed by pooling two markets together while permitting the intercepts and individual coefficients to differ across markets. Under this pooled regression approach, the computation of estimate of the residual variance s2u was based on the sum of squared residuals over the two market sectors instead of being estimated individually [21]. By doing so, the parameter differences across two markets could be tested directly. Mathematically, the integrated empirical models used for describing the price of fresh or flush water pumps within these two market sectors could be represented by the following ‘unrestricted’ form: LnðPr iceÞ ¼ b0 þ Da0 þ b1 V þ a1 DV þ b2 H þ a2 DH; ð1Þ where D is the dummy variable with D ¼ 0 and 1 representing the competitive market and the developer’s market sector, respectively. V is the volumetric flow rates (in l/s) and H is the pressure head (in m) for water pumps. The implicit price characteristics for different operating characteristics of water pumps being supplied to two different market sectors could be determined from the respective coefficients within the developed hedonic price models (1): bi
for i ¼ 0; 1; 2 for competitive market; and
bi þ ai for i ¼ 0; 1; 2
for developer’s market:
Accordingly, the as measure the market-specific implicit prices for different operating characteristics of water pumps, i.e. as measure the difference between parameter effects of individual operating characteristics of water pumps for competitive and developer’s market sectors. Consequently, the possible differences in characteristic implicit prices for two markets were tested by using null hypothesis H0 : a0 ¼ a1 ¼ a2 ¼ 0 and the alternative hypothesis H1 : at least one of the ai a0: If the null hypothesis is accepted, i.e. a0 ¼ a1 ¼ a2 ¼ 0; the equation (1) will become ‘restricted’ (hereinafter called ‘restricted’ model) LnðPr iceÞ ¼ b0 þ b1 V þ b2 H:
ð2Þ
Table 1 shows the F-test results for comparing the different model forms used for predicting the pricing levels of flush and fresh water pumps where SSE R and SSE U are the sum of squared residuals for ‘Restricted’ and ‘Unrestricted’ models, respectively. ‘Unrestricted’ model has a functional form shown in Eq. (1). ‘Restricted’ model has the same functional form as
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Table 1 F-test results for the pricing model forms used for predicting the prices of flush and fresh water pumps Flush water pumps
Fresh water pumps
SSE R ¼ 7:695; SSE U ¼ 7:544 J ¼ 3; T K ¼ 97 6 ¼ 91; F ¼ ðSSE R SSE U ÞðT KÞ=JSSE U ¼ 0:607
SSE R ¼ 8:7; SSE U ¼ 8:568 J ¼ 3; T K ¼ 89 6 ¼ 83; F ¼ ðSSE R SSE U ÞðT KÞ=JSSE U ¼ 0:426
‘Unrestricted’ model except for all as are equal to zero. J is the number of coefficient different for the two models. ðT KÞ is the number of degrees of freedom in the unrestricted model. If the null hypothesis is true, the test statistic F will has an F-distribution with J numerator degrees of freedom and ðT KÞ denominator degrees of freedom, F ðJ;NKÞ : The null hypothesis will not be ‘‘accepted’’ if F 4 ¼ F t1;t2;a , where F t1;t2;a is the critical value for the level of significance a: As our results indicated that the null hypothesis could not be rejected at 0.05 significant level (F 3;91;0:05 ¼ 2:74F flush ¼ 0:607), all the as in model form (1) would become zeros. Thus, the estimated hedonic price models for the flush and fresh water pumps being supplied to the developer and the clients in the competitive market could be simplified and rewritten by using a single equation for each type of water pumps. Flush water pumps: LnðPr iceÞ ¼ 9:772 þ 0:03458V þ 0:007561H; adj-R2 ¼ 0:615:
ð3Þ
Fresh water pumps: LnðPr iceÞ ¼ 9:857 þ 0:02156V þ 0:006433H; adj-R2 ¼ 0:624:
ð4Þ
As the pricing levels in the developed models were determined to be independent of the characteristics of the supply market, the price structures of fresh and flush water pumps for both the competitive and developer’s market sectors between January 1998 and March 2001 were considered to be the same statistically. In other words, the rates of increase in pricing levels of fresh and flush water pumps due to increase in volumetric flow rate and/or pressure head were determined to be similar for these two sectors. 4.2. Inadequate competitiveness in market supply Apparently, the developer was succeeded in securing a competitive supply of fresh and flush water pumps by relaxing the pre-qualification requirements. However, it should not overlook the findings from our specification review that the quality standards of water pumps being supplied to the developer were much lower than those being supplied to the competitive sector. The lower quality standards of water pumps supplied to the
developer could be reflected by the inferior quality materials being used for the construction of their casings. Pumps constructed with relatively cheaper cast iron casings were frequently used within the developer market sector. In contrast, pumps constructed with more expensive zinc-free bronze casings were commonly used in the competitive market sector, even though stainless steel casings were sometimes used in those highend housing projects. The differences in the quality standards of pump casing used within these two sectors were mainly due to the differences in their practices adopted in prescribing specific requirements on pre-qualifying the flush and fresh water pumps supply. Generally, the requirements prescribed by the clients within the competitive market sector on the material construction for pump casings were far more specific and more stringent than those currently prescribed by the developer. More specifically, the clients in the competitive market sector required the type of materials used for the construction of pump casings to be conformed to a particular group and grade of the relevant British Standards. In contrast, the developer has adopted a more flexible approach by allowing a wide range of materials, ranging from cast iron, zinc-free bronze to stainless steel, to be used in the construction of pump casings. Even though the requirements imposed by the developer on the casing materials were less specific and less stringent, those imposed on the quality assurance procedures were much stricter. In particular, the developer required the potential entrant suppliers to submit product test reports and certificates before considering their applications to enroll into the pre-qualification list. However, the clients in the competitive sector normally did not lay down such types of requirements in their specification standards. Table 2 shows a detailed comparison of differences in requirements for fresh and flush water pumps specified by the developer and the clients in the competitive sector. Given that the water pumps supplied were of lower quality standards but at pricing levels comparable to the competitive market, the developer might not be able to obtain true value for money in the supply of the water pumps. Upon close examination, this should be due to lack of genuine competitiveness among the water pumps suppliers in the market supply to the developer. Indeed, this could be revealed by examining the total market
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Table 2 Major differences in the requirements for fresh and flush water pumps specified by the developer and the clients in the competitive sector (a) Pump construction (i) Material clients in the competitive sector required materials to be conformed to a particular group or grade number in the British Standards, while the developer specified a wide range of materials without specific group and grade number (b) Quality surveillance requirements (i) Submission document required by the developer but not the clients in the competitive sector pump test certificates acoustic performance test report (ii) Site test required by the developer but not the clients in competitive sector pump alignment test insulation test on motors earth loop impedance test on motors
Fig. 1. Market share among different fresh water pump brands supplied to the developer from January 1, 1998 to March 31, 2001. Note: number in parenthesis indicates the total number of water pumps supply contracts being awarded to individual suppliers.
Fig. 2. Market share among different flush water pump brands supplied to the developer from January 1, 1998 to March 31, 2001. Note: number in parenthesis indicates the total number of water pumps supply contracts being awarded to individual suppliers.
share profiles of the supply of fresh and flush water pumps to the developer between January 1, 1998 and March 31, 2001. Figs. 1 and 2 showed that the market supply of both fresh and flush water pumps were dominated by the two leading suppliers even though there were altogether six suppliers in the pre-qualification list. It can be seen that 90% of the total market shares were dominated by two leading suppliers, with more than 65% of the total market shares being dominated by a single supplier alone. The occurrence of these peculiar market characteristics indicated that the suppliers in the pre-qualification list did not work together in determining the pricing levels for the water pumps. In fact, they did compete with each other for the water pumps supply contracts. In view of the fact that the acceptance of bids was based on the lowest prices criterion, the two lead-
ing suppliers should have manipulated their pricing levels (so-called ‘Limit Pricing Strategy’) such that they could secure more than 90% of total number of the supply contracts between January 1, 1998 and March 31, 2001. By doing so, the two leading suppliers should have earned a good profit since they had substantially lower production costs as a result of the inferior quality water pumps offered. In contrast, the pricing levels currently charged to the developer did not seem to be attractive for the other four suppliers in the pre-qualification list. This was probably because these suppliers were not able to make any reasonable profits after taking into account their own production costs and the additional capital outlay required for complying with all the onerous and tedious quality assurance and entrance requirements laid down by the developer.
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5. Conclusions This study should be considered as one of pioneering studies that demonstrates the successful application of a quantitative approach for examining the effect of the pre-qualification requirement on competitiveness in the supply market of construction products and equipment. The findings of this study should add to our understanding on the effect of the stringency of the pre-qualification requirements on the price competitiveness in the supply market of building products and equipment. 5.1. Quantitative approach Integrated hedonic price models have been formulated for revealing any potential price differences being charged between the developer’s and competitive market sectors. Even though the concept of integrated hedonic price models has previously been applied in comparing the prices of pharmaceutical drugs across the markets of different countries [21], they have been specially modified in this study to suit the peculiar characteristics of water pumps as well as the current contractual practice within the building service industries in Hong Kong. In this study, the approach of formulating the integrated hedonic price models has been articulated in the way in which appropriate data have been collected. Firstly, 30 residential projects were randomly selected across a wide spectrum of large-scale private developers in Hong Kong to represent the competitive market sector. The number and the source of the projects selected in this study was considered appropriate as there were only a limited number of residential projects being launched in the past 5 years due to the economic downturn. Secondly, only project samples of comparable nature were selected so as to restrict the number and the range of values of confounding factors to a minimum in order to give meaningful results. As a result, only residential projects have been included in our analysis as the nature of projects was expected to have important impact on the volumetric flow rates and pressure heads of water pumps required. Finally, the samples of projects selected from the developer’s and the competitive market were drawn from the same tendering period so as to minimize the impact due to the changing economic conditions. However, the findings derived from the developed approach depend on three major assumptions. Firstly, the unit rates extracted from the schedule of rates from successful tenders could be used to represent the competitive pricing levels charged to the developer’s and competitive market sectors. The unit rates used were considered as a compromise between practicality and availability, since sensitive and confidential cost data
could not be readily collected from suppliers or contractors. Secondly, the pricing levels of water pumps were assumed to be linearly proportional to their volumetric flow rates irrespective of the ranges of volumetric rates of water pumps used. Thirdly, the hidden price-cost margin derived from the imperfect market was assumed not to incur significant bias in estimates of the implicit prices for water pumps, which would not affect the validity of hedonic price models. 5.2. Effect of relaxing the pre-qualification requirements Imposing proper pre-qualification requirements are always being considered to be one of the crucial measures for ensuring the quality of final products to be in line with the needs of the clients. Unfortunately, the practice of prescribing the pre-qualification requirements is always perceived as a state of art rather than science and it should be handled cautiously. Improper pre-qualification requirements can be very costly for the clients due to the lack of competitiveness and potential collusion among the limited number of competitors. Accordingly, the stringency of the pre-qualification requirements imposed should be balanced against their likely cost implication. If the pre-qualification requirements imposed are too stringent, fewer market players will become eligible for competing for the supply tenders, and thus less intense will be the competition. The lesser the degree of competition, the greater chance of having higher prices charged. Arguably, the practice of imposing too stringent pre-qualification requirements should be avoided as much as possible unless a special or higher quality standard requirement is considered to be indispensable. In contrast, there is always a belief that the degree of competition can be intensified by relaxing the prequalification requirements. However, the findings from this study indicate that the degree of competition may even be reduced as a result of relaxing the prequalification requirements to a level well below the industry norm. Indisputably, relaxing the pre-qualification requirements may lead to an increase in the number of market players qualified for the prescribed requirements. However, not all the qualified market players may not be able to or interested in enrolling into the prequalification list as a result of the existence of some entry barriers. The entry barriers may in turn be created by the imposition of onerous and tedious administrative pre-qualification requirements by the clients and/or some types of peculiar marketing strategy imposed by some players in the market. Given that it is difficult to ensure market competitiveness by manipulating the stringency of the prequalification requirements, the number of market players being enrolled in the pre-qualification list is frequently employed as an indicator for revealing the
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degree of competitiveness in a supply market. Many research studies and tendering guidelines advocated that adequate competitiveness in the market supply can be safeguarded by including an optimum number of market players into the pre-qualification list [22,23]. However, the findings from this study suggest that this may not necessarily to be true. Given that the contracts are awarded based on the lowest price criterion, the competitiveness of the market supply may not be enhanced even if more players have been included in the pre-qualification list. This certainly will be the case when the products being offered by all these players are of better quality and substantially higher production costs than those currently being supplied to the market. In other words, adequate competitiveness in the market supply can only be ensured provided that an optimum number of market players have successfully been included in the pre-qualification list, and the products being offered by all these players are of comparable quality standards. More radically, the issue of inadequate competitiveness can be resolved by revolutionizing the current tender selection process. Instead of solely based on the lowest bid win criterion, other criteria relating to the likely performance of the market players (such as product quality, quality surveillance scheme, structure and financial stability of market players’ organizations, etc) should also be considered during tender selection process. Multi-criteria decision analysis methods can be employed to handle the tender selection process by assigning a set of importance weights predetermined by clients or developers for different criteria. By doing so, the chances of having the market players offering lower quality products dominated the supply market should be reduced.
Acknowledgements This work was financially supported by the Hong Kong Polytechnic University through Research Grant No. GT-837. References [1] The Hong Kong Housing Authority. The administrative rule of control list II, 2002.
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[2] Palaneeswaran E, Kumaraswamy M. Recent advances and proposed improvements in contractors’ prequalification methodologies. Building and Environment 2001;35:73–87. [3] Friedman M. A competitive-bidding strategy. Operations Research 1956;4(1):104–12. [4] Gates M. Bidding strategies and probabilities. Journal of the Construction Division ASCE 1967;93(1):75–103. [5] Carr RI. Impact of number of bidders on competition. Journal of Construction Engineering and Management 1983;109(1):61–73. [6] Gaver KM, Zimmermann JL. An analysis of competitive bidding on BART contracts. Journal of Business 1977;50(3):275–95. [7] Gregory PR. Essential of economics, 5th ed. Addision-Wesley: Reading, MA; 2002. [8] Hirshleifer J, Hirshlerifer D. Price theory and applications, 6th ed. Englewood Cliffs, NJ: Prentice-Hall; 1998. [9] Lo W, Krizek RJ, Hadavi A. Effects of high pre-qualification requirements. Construction Management and Economics 1999; 17:603–12. [10] Chau CK, Du Y, Lee WL, Tse MS, Burnett J. Monitoring the competitiveness in the supply of low-voltage switchboards. Building and Environment 2003;38:787–93. [11] Chang YH, Yeh CH. Evaluating airline competitiveness using multiattribute decision making. Omega 2001;29:405–15. [12] Skitmore M. Identifying non-competitive bids in construction contract auctions. Omega 2002; 443–9. [13] Whilhelmsson M. The impact of traffic noise on the values of single-family houses. Journal of Environmental Planning and Management 2000;43(6):799–815. [14] Tyrvainen L, Miettinen A. Property prices and urban forest amenities. Journal of Environmental Economics and Management 2000;39:205–23. [15] HMK, Chan PPK, Cho YS. A hedonic price model for private properties in Hong Kong. Journal of Real Estate Finance and Economics 1995;10:37–48. [16] Rosen SM. Hedonic price functions and the measurement of preferences: the case of Swedish wine consumers. European Economic Review 1974;39:697–716. [17] Silver M. Hedonic regressions: an application to VCRs using scanner data. Omega 2000;28:399–408. [18] Baltas G, Freeman J. Hedonic price methods and the structure of high technology industrial markets an empirical analysis. Industrial Marketing Management 2001;30:599–607. [19] Arnade C, Pick Daniel. Alternative approach to measuring oligopoly power: a wheat example. Applied Economics Letters 1999;6:195–7. [20] Halstead JM, Bouvier RA, Hansen BE. On the issue of functional form choice in hedonic price functions: further evidence. Environmental Management 1997;21(5):759–65. [21] Danzon PM, Chao LW. Cross-national price differences for pharmaceutical: how large and why? Journal of Health Economics 2000;19:159–95. [22] De Boer L, van Dijkhuizen G, Telgen J. A basis for modeling the costs of supplier selection: the economic tender quantity. Journal of the Operational Research Society 2000;51(10):1128–35. [23] Leenders MR, Fearson HE. Purchasing and materials management: text and cases. New York: McGraw-Hill; 1993.
Building and Environment 40 (2005) 213–219 www.elsevier.com/locate/buildenv
On the study of the impact of relaxing the pre-qualification requirements on the competitiveness in the supply of water pumps C.K. Chau, W.L. Lee, J. Burnett, M.Y. Law, T.M. Leung Department of Building Services Engineering,The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong, SAR Received 4 February 2004; received in revised form 1 July 2004; accepted 13 July 2004
Abstract This paper reports a pioneering and quantitative approach being developed for assisting a large-scale high-rise residential building developer in Hong Kong in monitoring the competitiveness in the supply of fresh and flush water pumps to the building development projects. Integrated empirical pricing models based upon the hedonic price technique have been developed for the supply of both fresh and flush water pumps to the developer and the competitive sector. Our results revealed that the pricing levels charged to the developer were comparable to the competitive sector even though the quality standards of water pumps delivered were much lower. Upon close examination of the market structure, it was found that this was possibly due to the Limit Pricing Strategy being adopted by two leading suppliers in the developer’s market as a result of relaxing the pre-qualification to standards below the industry norm. This finding should add to our understanding on the impact on the market competitiveness due to relaxation of pre-qualification requirements. Besides, measures of enhancing competitiveness in the supply market have also been discussed. r 2004 Elsevier Ltd. All rights reserved. Keywords: Pre-qualification; Competitiveness; Specification; Mechanical equipment in buildings
1. Introduction This paper investigates the effect on market competitiveness as a result of a strategy of laying down less stringent and less specific pre-qualification requirements for the supply of flush and fresh water pumps to a largescale high-rise residential building developer in Hong Kong. This paper reports on the findings of a consultancy study on whether comparable market prices were being charged by monitoring the pricing levels of flush and fresh water pumps supplied to the developer, reviewing the market structure as well as relevant specification standards. It is expected that the findings should add to our understanding on the issue whether greater degree of competitiveness can be Corresponding author. Tel.: +852-2766-7780; fax: +852-2774-6146. E-mail address: [email protected] (C.K. Chau).
0360-1323/$ - see front matter r 2004 Elsevier Ltd. All rights reserved. doi:10.1016/j.buildenv.2004.07.006
enhanced by reducing the stringency of the prequalification requirements.
2. Background Pre-qualification requirements are generally employed by the clients in the construction industry to identify a group of qualified market players so as to minimize the efforts of the project teams, improve the operation efficiency of the vetting procedures [1], and maximize the probability of obtaining a quality product [2]. More specifically, pre-qualification requirements define the minimum quality threshold before any market players are allowed to be included in the pre-qualification list and to tender for material supply or construction contracts. However, the imposition of pre-qualification requirements of any forms will restrict the degree of competition in the existing supply market. With more
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stringent pre-qualification requirement imposed, fewer market players are able to meet the requirements. The smaller the number of qualified market players, the greater possibilities of having high prices charged [3–6]. In cases where the market is dominated by a small group of market players, some forms of oligopoly or even collusive practice will be developed in the market. This will likely result in unreasonably increase in the prices charged [7,8]. On the other hand, relaxing the prequalification requirement is always perceived to be an effective strategy for resolving the issue of inadequate competitiveness [9]. Generally, relaxation of pre-qualification requirements can lead to an increase in the number of qualified market players, and presumably also an increase in the market competitiveness. The findings from some studies reinforced this proposition that the degree of competition would become more intense with the relaxation of the pre-qualification requirements. Our previous study also revealed that the price of switchboards would become more competitive as a result of relaxing the stringent pre-qualification requirements so as to in line with the industry norms on both product quality and quality surveillance requirements [10]. However, market competitiveness may not always be increased since there is not a wellproven direct relationship between the number of qualified market players and the degree of market competitiveness. Accordingly, this study intends to bridge this gap by focusing on the effect on the market competitiveness due to the relaxation of the pre-qualification requirements through a detailed examination on the market supply of fresh and flush water pumps to the developer. Nevertheless, this issue cannot be successfully addressed without first developing a logical, scientific and yet practical protocol for evaluating the competitiveness of supply in the fresh and flush water pumps. Even though there was a similar protocol being developed for evaluating the price competitiveness of the low-voltage switchboards supplied to the developer [10], the key price indicator used was only derived from the rule of thumb adopted by the industry. This paper intends to overcome this shortcoming by developing a practical protocol with the aid of appropriate theoretical econometric models. The final models would be formulated by identifying a practical way of acquiring reliable and sensitive cost data; and addressing the special characteristics of fresh and flush water pumps, and the building industries.
3. Methodology Our fundamental interest in this study was to reveal whether the imposition of relaxed pre-qualification requirements by a large-scale housing developer in
Hong Kong on the fresh and flush water pumps could lead to a reasonable degree of competitiveness in their supplies. However, this issue cannot be easily addressed without clearly defining what competitiveness is. Unfortunately, up to date, competitiveness does not have a unanimous definition and it may even have different meanings in different context [11]. As the concept of competitiveness is considered to be context dependent, its measurement should reflect the type of competitive environment investigated. In construction projects, the degrees of competitiveness are commonly measured by the closeness in the bid values being put forward by tenderers [12]. The closer the bid values being put forward by the tenderers, the more competitive the market supply will be. However, this can only be applicable on individual project or tender levels as competitive in individual tender levels may not necessarily imply that they are also competitive in the broad industry levels. Given that the objective of this study is to reveal the competitiveness of market supply to the developer, competitiveness in the following context is measured by how comparable in the pricing levels being charged to the developer and the clients in the competitive market sector. In order to monitor the degree of competitiveness in pricing levels of fresh and flush water pumps supplied to the developer, empirical pricing models based upon the hedonic price technique have been developed for the supply of each type of water pumps to the developer and the clients in the competitive market sector. Hedonic price technique rests on the hypothesis that a consumer when consuming a particular commodity is consuming the different characteristics of the commodity. Specifically, the technique is based on a regression analysis of the price on the characteristics (attributes) of the commodity with an objective of revealing the implicit prices a consumer places on additional unit of characteristic for a particular commodity [13–16]. Theoretically, the implicit prices for different attributes of a commodity could be computed, so that comparison on pricing levels could subsequently be made on an equivalent quality standard [17,18]. In this study, regression analysis was conducted using the unit pricing rates of the fresh and flush water pumps, and their product characteristics as dependent and independent variables, respectively. The unit pricing rates for fresh and flush water pumps were extracted from the schedules of rates, which were a notional breakdown of work items and their associated pricing for individual projects, from the successful tenderers for individual projects. Apart from unit rates, design details of the fresh and flush water pumps, such as volumetric flow rates and total pressure heads, were extracted from the tender drawings of individual projects. Types of materials used for construction of casings for pumps, and other special requirements on design, construction
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and quality assurance were extracted from the specification standards associated with the project. All the required information was extracted from both the residential projects from the developer’s and the competitive market with tendering-in dates falling between January 1, 1998 and March 31, 2001. As a result, information was collected from 67 residential projects from the developer, and 30 residential projects from the competitive market, which was formulated by a wide spectrum of large-scale developers in Hong Kong.
4. Results and analysis 4.1. Competitiveness on the pricing levels of water pumps supply to developer Intuitively, simple statistical t-tests could be used for comparing the mean pricing levels charged to the developer and the clients in the competitive market sector. However, such type of comparison method was only considered to be appropriate if the characteristics and standards of water pumps used by the developer and the clients in the competitive market sector were identical. However, there were substantial differences on the operating characteristics of water pumps being adopted by the developer and the clients in the competitive market sector. The types of water pumps adopted by the developer were generally having larger volumetric flow rates since the housing estates constructed by the developer had more apartment units and higher occupant densities per floor. Given that the operating characteristics of water pumps used within these two sectors were different, they should be treated as heterogeneous products in our analysis. Hedonic price models were used in this study for describing the prices of fresh and flush water pumps in terms of their operating characteristics. As mentioned previously, they were developed by regressing the pricing levels of the water pumps on their operating characteristics so as to determine the implicit prices a consumer places on additional units of these operating characteristics. However, neither economic theory nor earlier researches in this field does prescribe any specific functional form that should be adopted for these types of regression models. Without a practical guidance, the adoption of empirical estimation of hedonic price requires a careful choice of functional form [19,20]. In this study, log-linear forms were chosen in this study for representing the prices of both fresh and flush water pumps since they were more plausible and they produced reasonable coefficients of determination. Specifically, the log of prices of fresh and flush water pumps were individually regressed against both the
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corresponding volumetric flow rates (V) and the pressure heads (H). In order to examine the issue on whether the pricing levels were comparable within these two different market sectors, fully integrated hedonic pricing models have been constructed for both fresh and flush water pumps. The models were developed by pooling two markets together while permitting the intercepts and individual coefficients to differ across markets. Under this pooled regression approach, the computation of estimate of the residual variance s2u was based on the sum of squared residuals over the two market sectors instead of being estimated individually [21]. By doing so, the parameter differences across two markets could be tested directly. Mathematically, the integrated empirical models used for describing the price of fresh or flush water pumps within these two market sectors could be represented by the following ‘unrestricted’ form: LnðPr iceÞ ¼ b0 þ Da0 þ b1 V þ a1 DV þ b2 H þ a2 DH; ð1Þ where D is the dummy variable with D ¼ 0 and 1 representing the competitive market and the developer’s market sector, respectively. V is the volumetric flow rates (in l/s) and H is the pressure head (in m) for water pumps. The implicit price characteristics for different operating characteristics of water pumps being supplied to two different market sectors could be determined from the respective coefficients within the developed hedonic price models (1): bi
for i ¼ 0; 1; 2 for competitive market; and
bi þ ai for i ¼ 0; 1; 2
for developer’s market:
Accordingly, the as measure the market-specific implicit prices for different operating characteristics of water pumps, i.e. as measure the difference between parameter effects of individual operating characteristics of water pumps for competitive and developer’s market sectors. Consequently, the possible differences in characteristic implicit prices for two markets were tested by using null hypothesis H0 : a0 ¼ a1 ¼ a2 ¼ 0 and the alternative hypothesis H1 : at least one of the ai a0: If the null hypothesis is accepted, i.e. a0 ¼ a1 ¼ a2 ¼ 0; the equation (1) will become ‘restricted’ (hereinafter called ‘restricted’ model) LnðPr iceÞ ¼ b0 þ b1 V þ b2 H:
ð2Þ
Table 1 shows the F-test results for comparing the different model forms used for predicting the pricing levels of flush and fresh water pumps where SSE R and SSE U are the sum of squared residuals for ‘Restricted’ and ‘Unrestricted’ models, respectively. ‘Unrestricted’ model has a functional form shown in Eq. (1). ‘Restricted’ model has the same functional form as
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Table 1 F-test results for the pricing model forms used for predicting the prices of flush and fresh water pumps Flush water pumps
Fresh water pumps
SSE R ¼ 7:695; SSE U ¼ 7:544 J ¼ 3; T K ¼ 97 6 ¼ 91; F ¼ ðSSE R SSE U ÞðT KÞ=JSSE U ¼ 0:607
SSE R ¼ 8:7; SSE U ¼ 8:568 J ¼ 3; T K ¼ 89 6 ¼ 83; F ¼ ðSSE R SSE U ÞðT KÞ=JSSE U ¼ 0:426
‘Unrestricted’ model except for all as are equal to zero. J is the number of coefficient different for the two models. ðT KÞ is the number of degrees of freedom in the unrestricted model. If the null hypothesis is true, the test statistic F will has an F-distribution with J numerator degrees of freedom and ðT KÞ denominator degrees of freedom, F ðJ;NKÞ : The null hypothesis will not be ‘‘accepted’’ if F 4 ¼ F t1;t2;a , where F t1;t2;a is the critical value for the level of significance a: As our results indicated that the null hypothesis could not be rejected at 0.05 significant level (F 3;91;0:05 ¼ 2:74F flush ¼ 0:607), all the as in model form (1) would become zeros. Thus, the estimated hedonic price models for the flush and fresh water pumps being supplied to the developer and the clients in the competitive market could be simplified and rewritten by using a single equation for each type of water pumps. Flush water pumps: LnðPr iceÞ ¼ 9:772 þ 0:03458V þ 0:007561H; adj-R2 ¼ 0:615:
ð3Þ
Fresh water pumps: LnðPr iceÞ ¼ 9:857 þ 0:02156V þ 0:006433H; adj-R2 ¼ 0:624:
ð4Þ
As the pricing levels in the developed models were determined to be independent of the characteristics of the supply market, the price structures of fresh and flush water pumps for both the competitive and developer’s market sectors between January 1998 and March 2001 were considered to be the same statistically. In other words, the rates of increase in pricing levels of fresh and flush water pumps due to increase in volumetric flow rate and/or pressure head were determined to be similar for these two sectors. 4.2. Inadequate competitiveness in market supply Apparently, the developer was succeeded in securing a competitive supply of fresh and flush water pumps by relaxing the pre-qualification requirements. However, it should not overlook the findings from our specification review that the quality standards of water pumps being supplied to the developer were much lower than those being supplied to the competitive sector. The lower quality standards of water pumps supplied to the
developer could be reflected by the inferior quality materials being used for the construction of their casings. Pumps constructed with relatively cheaper cast iron casings were frequently used within the developer market sector. In contrast, pumps constructed with more expensive zinc-free bronze casings were commonly used in the competitive market sector, even though stainless steel casings were sometimes used in those highend housing projects. The differences in the quality standards of pump casing used within these two sectors were mainly due to the differences in their practices adopted in prescribing specific requirements on pre-qualifying the flush and fresh water pumps supply. Generally, the requirements prescribed by the clients within the competitive market sector on the material construction for pump casings were far more specific and more stringent than those currently prescribed by the developer. More specifically, the clients in the competitive market sector required the type of materials used for the construction of pump casings to be conformed to a particular group and grade of the relevant British Standards. In contrast, the developer has adopted a more flexible approach by allowing a wide range of materials, ranging from cast iron, zinc-free bronze to stainless steel, to be used in the construction of pump casings. Even though the requirements imposed by the developer on the casing materials were less specific and less stringent, those imposed on the quality assurance procedures were much stricter. In particular, the developer required the potential entrant suppliers to submit product test reports and certificates before considering their applications to enroll into the pre-qualification list. However, the clients in the competitive sector normally did not lay down such types of requirements in their specification standards. Table 2 shows a detailed comparison of differences in requirements for fresh and flush water pumps specified by the developer and the clients in the competitive sector. Given that the water pumps supplied were of lower quality standards but at pricing levels comparable to the competitive market, the developer might not be able to obtain true value for money in the supply of the water pumps. Upon close examination, this should be due to lack of genuine competitiveness among the water pumps suppliers in the market supply to the developer. Indeed, this could be revealed by examining the total market
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Table 2 Major differences in the requirements for fresh and flush water pumps specified by the developer and the clients in the competitive sector (a) Pump construction (i) Material clients in the competitive sector required materials to be conformed to a particular group or grade number in the British Standards, while the developer specified a wide range of materials without specific group and grade number (b) Quality surveillance requirements (i) Submission document required by the developer but not the clients in the competitive sector pump test certificates acoustic performance test report (ii) Site test required by the developer but not the clients in competitive sector pump alignment test insulation test on motors earth loop impedance test on motors
Fig. 1. Market share among different fresh water pump brands supplied to the developer from January 1, 1998 to March 31, 2001. Note: number in parenthesis indicates the total number of water pumps supply contracts being awarded to individual suppliers.
Fig. 2. Market share among different flush water pump brands supplied to the developer from January 1, 1998 to March 31, 2001. Note: number in parenthesis indicates the total number of water pumps supply contracts being awarded to individual suppliers.
share profiles of the supply of fresh and flush water pumps to the developer between January 1, 1998 and March 31, 2001. Figs. 1 and 2 showed that the market supply of both fresh and flush water pumps were dominated by the two leading suppliers even though there were altogether six suppliers in the pre-qualification list. It can be seen that 90% of the total market shares were dominated by two leading suppliers, with more than 65% of the total market shares being dominated by a single supplier alone. The occurrence of these peculiar market characteristics indicated that the suppliers in the pre-qualification list did not work together in determining the pricing levels for the water pumps. In fact, they did compete with each other for the water pumps supply contracts. In view of the fact that the acceptance of bids was based on the lowest prices criterion, the two lead-
ing suppliers should have manipulated their pricing levels (so-called ‘Limit Pricing Strategy’) such that they could secure more than 90% of total number of the supply contracts between January 1, 1998 and March 31, 2001. By doing so, the two leading suppliers should have earned a good profit since they had substantially lower production costs as a result of the inferior quality water pumps offered. In contrast, the pricing levels currently charged to the developer did not seem to be attractive for the other four suppliers in the pre-qualification list. This was probably because these suppliers were not able to make any reasonable profits after taking into account their own production costs and the additional capital outlay required for complying with all the onerous and tedious quality assurance and entrance requirements laid down by the developer.
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5. Conclusions This study should be considered as one of pioneering studies that demonstrates the successful application of a quantitative approach for examining the effect of the pre-qualification requirement on competitiveness in the supply market of construction products and equipment. The findings of this study should add to our understanding on the effect of the stringency of the pre-qualification requirements on the price competitiveness in the supply market of building products and equipment. 5.1. Quantitative approach Integrated hedonic price models have been formulated for revealing any potential price differences being charged between the developer’s and competitive market sectors. Even though the concept of integrated hedonic price models has previously been applied in comparing the prices of pharmaceutical drugs across the markets of different countries [21], they have been specially modified in this study to suit the peculiar characteristics of water pumps as well as the current contractual practice within the building service industries in Hong Kong. In this study, the approach of formulating the integrated hedonic price models has been articulated in the way in which appropriate data have been collected. Firstly, 30 residential projects were randomly selected across a wide spectrum of large-scale private developers in Hong Kong to represent the competitive market sector. The number and the source of the projects selected in this study was considered appropriate as there were only a limited number of residential projects being launched in the past 5 years due to the economic downturn. Secondly, only project samples of comparable nature were selected so as to restrict the number and the range of values of confounding factors to a minimum in order to give meaningful results. As a result, only residential projects have been included in our analysis as the nature of projects was expected to have important impact on the volumetric flow rates and pressure heads of water pumps required. Finally, the samples of projects selected from the developer’s and the competitive market were drawn from the same tendering period so as to minimize the impact due to the changing economic conditions. However, the findings derived from the developed approach depend on three major assumptions. Firstly, the unit rates extracted from the schedule of rates from successful tenders could be used to represent the competitive pricing levels charged to the developer’s and competitive market sectors. The unit rates used were considered as a compromise between practicality and availability, since sensitive and confidential cost data
could not be readily collected from suppliers or contractors. Secondly, the pricing levels of water pumps were assumed to be linearly proportional to their volumetric flow rates irrespective of the ranges of volumetric rates of water pumps used. Thirdly, the hidden price-cost margin derived from the imperfect market was assumed not to incur significant bias in estimates of the implicit prices for water pumps, which would not affect the validity of hedonic price models. 5.2. Effect of relaxing the pre-qualification requirements Imposing proper pre-qualification requirements are always being considered to be one of the crucial measures for ensuring the quality of final products to be in line with the needs of the clients. Unfortunately, the practice of prescribing the pre-qualification requirements is always perceived as a state of art rather than science and it should be handled cautiously. Improper pre-qualification requirements can be very costly for the clients due to the lack of competitiveness and potential collusion among the limited number of competitors. Accordingly, the stringency of the pre-qualification requirements imposed should be balanced against their likely cost implication. If the pre-qualification requirements imposed are too stringent, fewer market players will become eligible for competing for the supply tenders, and thus less intense will be the competition. The lesser the degree of competition, the greater chance of having higher prices charged. Arguably, the practice of imposing too stringent pre-qualification requirements should be avoided as much as possible unless a special or higher quality standard requirement is considered to be indispensable. In contrast, there is always a belief that the degree of competition can be intensified by relaxing the prequalification requirements. However, the findings from this study indicate that the degree of competition may even be reduced as a result of relaxing the prequalification requirements to a level well below the industry norm. Indisputably, relaxing the pre-qualification requirements may lead to an increase in the number of market players qualified for the prescribed requirements. However, not all the qualified market players may not be able to or interested in enrolling into the prequalification list as a result of the existence of some entry barriers. The entry barriers may in turn be created by the imposition of onerous and tedious administrative pre-qualification requirements by the clients and/or some types of peculiar marketing strategy imposed by some players in the market. Given that it is difficult to ensure market competitiveness by manipulating the stringency of the prequalification requirements, the number of market players being enrolled in the pre-qualification list is frequently employed as an indicator for revealing the
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degree of competitiveness in a supply market. Many research studies and tendering guidelines advocated that adequate competitiveness in the market supply can be safeguarded by including an optimum number of market players into the pre-qualification list [22,23]. However, the findings from this study suggest that this may not necessarily to be true. Given that the contracts are awarded based on the lowest price criterion, the competitiveness of the market supply may not be enhanced even if more players have been included in the pre-qualification list. This certainly will be the case when the products being offered by all these players are of better quality and substantially higher production costs than those currently being supplied to the market. In other words, adequate competitiveness in the market supply can only be ensured provided that an optimum number of market players have successfully been included in the pre-qualification list, and the products being offered by all these players are of comparable quality standards. More radically, the issue of inadequate competitiveness can be resolved by revolutionizing the current tender selection process. Instead of solely based on the lowest bid win criterion, other criteria relating to the likely performance of the market players (such as product quality, quality surveillance scheme, structure and financial stability of market players’ organizations, etc) should also be considered during tender selection process. Multi-criteria decision analysis methods can be employed to handle the tender selection process by assigning a set of importance weights predetermined by clients or developers for different criteria. By doing so, the chances of having the market players offering lower quality products dominated the supply market should be reduced.
Acknowledgements This work was financially supported by the Hong Kong Polytechnic University through Research Grant No. GT-837. References [1] The Hong Kong Housing Authority. The administrative rule of control list II, 2002.
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