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Competition and Cost Overruns. Optimal Misspecification of Procurement Contracts

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Author Info
Juan J. Ganuza ()

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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.

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Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 471.

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Date of creation: Oct 1998
Date of revision: Mar 2002
Handle: RePEc:upf:upfgen:471

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Web page: http://www.econ.upf.edu/

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Related research
Keywords: Cost overruns procurement contracts strategic ignorance

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Find related papers by JEL classification:
L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation
H57 - Public Economics - - National Government Expenditures and Related Policies - - - Procurement
D44 - Microeconomics - - Market Structure and Pricing - - - Auctions

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  1. Cremer, Jacques & Khalil, Fahad, 1994. "Gathering information before the contract is offered: The case with two states of nature," European Economic Review, Elsevier, vol. 38(3-4), pages 675-682, April. [Downloadable!] (restricted)
  2. Caspar, Vitor & Leite, Antonio P. N., 1989. "Selection bias induced cost overruns," Information Economics and Policy, Elsevier, vol. 4(2), pages 175-187. [Downloadable!] (restricted)
  3. Tracy R. Lewis, 1986. "Reputation and Contractual Performance in Long-Term Projects," RAND Journal of Economics, The RAND Corporation, vol. 17(2), pages 141-157, Summer. [Downloadable!] (restricted)
  4. Milgrom, Paul & Shannon, Chris, 1994. "Monotone Comparative Statics," Econometrica, Econometric Society, vol. 62(1), pages 157-80, January. [Downloadable!] (restricted)
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  5. Lewis, Tracy R & Sappington, David E M, 1994. "Supplying Information to Facilitate Price Discrimination," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 35(2), pages 309-27, May. [Downloadable!] (restricted)
  6. Edlin, Aaron S. & Shannon, Chris, 1998. "Strict Monotonicity in Comparative Statics," Journal of Economic Theory, Elsevier, vol. 81(1), pages 201-219, July. [Downloadable!] (restricted)
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  7. M. Dewatripont & E. Maskin, 1995. "Contractual Contingencies and Renegotiation," RAND Journal of Economics, The RAND Corporation, vol. 26(4), pages 704-719, Winter. [Downloadable!] (restricted)
  8. Cremer, Jacques, 1995. "Arm's Length Relationships," The Quarterly Journal of Economics, MIT Press, vol. 110(2), pages 275-95, May. [Downloadable!] (restricted)
  9. Bos, Dieter & Lulfesmann, Christoph, 1996. " The Hold-Up Problem in Government Contracting," Scandinavian Journal of Economics, Blackwell Publishing, vol. 98(1), pages 53-74, March.
  10. Anke Kessler, 1998. "The Value of Ignorance," RAND Journal of Economics, The RAND Corporation, vol. 29(2), pages 339-354, Summer. [Downloadable!] (restricted)
  11. Hart, Oliver D & Moore, John, 1988. "Incomplete Contracts and Renegotiation," Econometrica, Econometric Society, vol. 56(4), pages 755-85, July. [Downloadable!] (restricted)
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  12. Chung, Tai-Yeong, 1991. "Incomplete Contracts, Specific Investments, and Risk Sharing," Review of Economic Studies, Blackwell Publishing, vol. 58(5), pages 1031-42, October. [Downloadable!] (restricted)
  13. Cremer, Jacques & Khalil, Fahad, 1992. "Gathering Information before Signing a Contract," American Economic Review, American Economic Association, vol. 82(3), pages 566-78, June. [Downloadable!] (restricted)
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Aleix Calveras & Juan J. Ganuza & Esther Hauk, 2001. "Wild Bids. Gambling for Resurrection in Procurement Contracts," Economics Working Papers 553, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 2001. [Downloadable!]
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