Limited liability and mechanism design in procurement

In the presence of cost uncertainty, limited liability introduces the possibility of default in procurement with its associated bank-ruptcy costs. When financial soundness is not perfectly observable, we show that incentive compatibility implies that financially less sound contractors are selected with higher probability in any feasible mechanism. Informational rents are associated with unsound financial situations. By selecting the financially weakest contractor, stronger price competition (auctions) may not only increase the probability of default but also expected rents. Thus, weak conditions are suffcient for auctions to be suboptimal. In particular, we show that pooling firms with higher assets may reduce the cost of procurement even when default is costless for the sponsor.

Competition and cost overruns. Optimal misspecification of procurement contracts

Most cases of cost overruns in public procurement are related to important changes in the initial project design. This paper deals with the problem of design specification in public procurement and provides a rationale for design misspecification. We propose a model in which the sponsor decides how much to invest in design specification and awards competitively the project to a contractor. After the project has been awarded the sponsor engages in bilateral renegotiation with the contractor, in order to accommodate changes in the initial project s design that new information makes desirable. When procurement takes place in the presence of horizontally differentiated contractors, the design s specification level is seen to affect the resulting degree of competition. The paper highlights this interaction between market competition and design specification and shows that the sponsor s optimal strategy, when facing an imperfectly competitive market supply, is to underinvest in design specification so as to make significant cost overruns likely. Since no such misspecification occurs in a perfectly competitive market, cost overruns are seen to arise as a consequence of lack of competition in the procurement market.

Allocating ideas: Horizontal competition in tournaments

We develop a stylized model of horizontal and vertical competition intournaments with two competing firms. The sponsor cares about the qualityof the design but also about the design location. A priori not even thesponsor knows his preferred design location, which is only discoveredonce he has seen the actual proposals. We show that the more efficientfirm is more likely to be conservative when choosing the design location.Also, to get some differentiation in design locations, the cost differencebetween contestants can neither be too small nor too big. Therefore, ifthe sponsor mainly cares about the design location, participation in thetournaments by the two lowest cost contestants cannot be optimal for thesponsor.

Competition and cost overruns in procurement

Most cases of cost overruns in public procurement are related to important changes in theinitial project design. This paper deals with the problem of design speciffication in public procurement and provides a rationale for design misspeciffication. We propose a model in which the sponsor decides how much to invest in design speciffication and awards competitively the project to a contractor. After the project has been awarded the sponsor engages in bilateral renegotiation with the contractor, in order to accommodate changes in the initial project's design that new information makes desirable. When procurement takes place in the presence of horizontally differentiated contractors, the design's speciffication level is seen to affect the resulting degree of competition. The paper highlights this interaction between market competition and design speciffication and shows that the sponsor's optimal strategy, when facing an imperfectly competitive market supply, is to underinvest in design speciffication so as to make signifficant cost overrunslikely. Since no such misspeciffication occurs in a perfectly competitive market, cost overruns are seen to arise as a consequence of lack of competition in the procurement market.

Heterogeneity-promoting optimal procurement

When procurement takes place in the presence of horizontally differentiated contractors, the design of the object being procured affects the resulting degree of competition. This paper highlights the interaction between theoptimal procurement mechanism and the design choice. Contrary to conventional wisdom, the sponsor's design choice, instead of homogenizingthe market to generate competition, promotes heterogeneity.