Procurement with Unforeseen Contingencies

44 Pages Posted: 23 Oct 2017

See all articles by Fabian Herweg

Fabian Herweg

University of Bayreuth - Faculty of Law, Business and Economics

Klaus M. Schmidt

Ludwig Maximilian University of Munich - Faculty of Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Date Written: October 2017

Abstract

The procurement of complex projects is often plagued by large cost overruns. One important reason for these additional costs are flaws in the initial design. If the project is procured with a price-only auction, sellers who spotted some of the flaws have no incentive to reveal them early. Each seller prefers to conceal his information until he is awarded the contract and then renegotiate when he is in a bilateral monopoly position with the buyer. We show that this gives rise to three inefficiencies: inefficient renegotiation, inefficient production and inefficient design. We derive the welfare optimal direct mechanism that implements the efficient allocation at the lowest possible cost to the buyer. The direct mechanism, however, imposes strong assumptions on the buyer's prior knowledge of possible flaws and their payoff consequences. Therefore, we also propose an indirect mechanism that implements the same allocation but does not require any such prior knowledge. The optimal direct and indirect mechanisms separate the improvement of the design and the selection of the seller who produces the good.

Keywords: Adaptation Costs, auctions, Behavioral Contract Theory, Design Flaws, Procurement, Renegotiation

JEL Classification: D44, D82, D83, H57

Suggested Citation

Herweg, Fabian and Schmidt, Klaus M., Procurement with Unforeseen Contingencies (October 2017). CEPR Discussion Paper No. DP12385. Available at SSRN: https://ssrn.com/abstract=3057319

Fabian Herweg (Contact Author)

University of Bayreuth - Faculty of Law, Business and Economics ( email )

Universit├Ątsstra├če 30
Bayreuth, 95447
Germany

Klaus M. Schmidt

Ludwig Maximilian University of Munich - Faculty of Economics ( email )

Ludwigstrasse 28
Munich, D-80539
Germany
+49 89 2180 3405 (Phone)
+49 89 2180 3510 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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