Procurement with Unforeseen Contingencies

Klaus Schmidt and Fabian Herweg

No 12385, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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: Procurement; Renegotiation; Auctions; Design flaws; Adaptation costs; Behavioral contract theory (search for similar items in EconPapers)
JEL-codes: D44 D82 D83 H57 (search for similar items in EconPapers)
Date: 2017-10
New Economics Papers: this item is included in nep-cta, nep-mic and nep-ppm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Related works:
Journal Article: Procurement with Unforeseen Contingencies (2020)
Working Paper: Procurement with Unforeseen Contingencies (2017)
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