Incentive Contracts, Adverse Selection, and Risk Transfer: Evidence from Procurement

26 Pages Posted: 9 Dec 2018

See all articles by Meng Liu

Meng Liu

Massachusetts Institute of Technology (MIT) - Sloan School of Management; Washington University in St. Louis

Chungsang Lam

Clemson University - John E. Walker Department of Economics

Date Written: June 27, 2017

Abstract

Multi-attribute auctions, designed to address multi-dimensional preference, make a good case study where incentive provisions interact with competition. By studying "Cost Time" highway procurement that aims to incentivize timely project delivery, we show that awarding incentive contracts by bidding mechanisms can yield sub-optimal outcomes. Our theory demonstrates that bidders, facing high-powered incentives and production uncertainty, optimally skew their time bids while transferring production risk to buying agencies. This gaming behavior leads to adverse selection and efficiency loss, in that a less-efficient bidder can outbid the efficient bidder due to the misalignment between bidder types and the auction rule that determines winners. We estimate our model using data from the California Department of Transportation and find that 18% of auctions are allocated to inefficient bidders. Counterfactual analyses suggest that procurement schemes with lower incentives can yield less mis-allocation with lower production costs and less buyer budget pressure.

Keywords: multi-attribute auctions, procurement, incentive contracts, adverse selection, incomplete contract

Suggested Citation

Liu, Meng and Lam, Chungsang, Incentive Contracts, Adverse Selection, and Risk Transfer: Evidence from Procurement (June 27, 2017). Available at SSRN: https://ssrn.com/abstract=3287195 or http://dx.doi.org/10.2139/ssrn.3287195

Meng Liu (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

Cambridge, MA 02139
United States

Washington University in St. Louis ( email )

One Brookings Drive
Campus Box 1208
Saint Louis, MO MO 63130-4899
United States

Chungsang Lam

Clemson University - John E. Walker Department of Economics ( email )

Clemson, SC 29634
United States

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