Incomplete Information and Optimal Market Structure: Public Purchases from Private Providers

Market structure is endogenized in a normative model of public procurement featuring a social cost of profit, product variety, economies of scale, and incomplete information about cost. Depending on parameters, either sole sourcing or dual sourcing might be optimal. However, if the social cost of profit is positive but not too large, incomplete information biases optimal market structure in favor of sole sourcing. On the other hand, this bias in favor of sole sourcing may be reversed if the social cost of profit is large. An application to the publicly financed treatment for drug abuse motivates the analysis. (January 1995)