Competition and Cost Overruns. Optimal Misspecification of Procurement Contracts

Universitat Pompeu Fabra Working Paper No. 471

29 Pages Posted: 3 Nov 2000

See all articles by Juan-José Ganuza

Juan-José Ganuza

Universitat Pompeu Fabra (UPF) - Faculty of Economic and Business Sciences

Date Written: March 2000

Abstract

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.

Keywords: cost overruns, procurement contracts, strategic ignorance

JEL Classification: L51, H57, D44

Suggested Citation

Ganuza, Juan, Competition and Cost Overruns. Optimal Misspecification of Procurement Contracts (March 2000). Universitat Pompeu Fabra Working Paper No. 471, Available at SSRN: https://ssrn.com/abstract=235520 or http://dx.doi.org/10.2139/ssrn.235520

Juan Ganuza (Contact Author)

Universitat Pompeu Fabra (UPF) - Faculty of Economic and Business Sciences ( email )

Ramon Trias Fargas 25-27
Barcelona, 08005
Spain
(34-93) 542 27 19 (Phone)
(34-98) 542 17 46 (Fax)

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