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Competition and cost overruns. Optimal misspecification of procurement contracts

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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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Bibliographic Info

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/

Related research

Keywords: Cost overruns; procurement contracts; strategic ignorance;

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  1. Cremer, Jacques, 1995. "Arm's Length Relationships," The Quarterly Journal of Economics, MIT Press, vol. 110(2), pages 275-95, May.
  2. Aaron S. Edlin and Chris Shannon., 1995. "Strict Monotonicity in Comparative Statics," Economics Working Papers 95-238, University of California at Berkeley.
  3. Oliver Hart & John Moore, 1985. "Incomplete Contracts and Renegotiation," Working papers 367, Massachusetts Institute of Technology (MIT), Department of Economics.
  4. Chung, Tai-Yeong, 1991. "Incomplete Contracts, Specific Investments, and Risk Sharing," Review of Economic Studies, Wiley Blackwell, vol. 58(5), pages 1031-42, October.
  5. Aghion, Philippe & Dewatripont, Mathias & Rey, Patrick, 1994. "Renegotiation Design with Unverifiable Information," Econometrica, Econometric Society, vol. 62(2), pages 257-82, March.
  6. Caspar, Vitor & Leite, Antonio P. N., 1989. "Selection bias induced cost overruns," Information Economics and Policy, Elsevier, vol. 4(2), pages 175-187.
  7. 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.
  8. 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.
  9. Cremer, J. & Khalil, F., 1991. "Gathering Information Before Signing a Contract," Discussion Papers in Economics at the University of Washington 91-16, Department of Economics at the University of Washington.
  10. Bos, Dieter & Lulfesmann, Christoph, 1996. " The Hold-Up Problem in Government Contracting," Scandinavian Journal of Economics, Wiley Blackwell, vol. 98(1), pages 53-74, March.
  11. Milgrom, P. & Shannon, C., 1991. "Monotone Comparative Statics," Papers 11, Stanford - Institute for Thoretical Economics.
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Cited by:
  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.

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