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Equilibrium Cost Overruns

  • Yongmin Chen

    (Department of Economics, University of Colorado at Boulder)

  • Ron Smith

    (Department of Economics, Birkbeck College, University of London)

Cost overruns are endemic in military procurement projects and pervasive in other areas. This paper studies a model in which the apparent cost overruns arise not as systematic expectational errors but as equilibrium phenomena. The possibility of renegotiating payments when cost overruns occur results in firms bidding below their true estimate of expected project costs. This can cause the initial price for a project to be consistently lower than its expected cost, and hence the persistence of cost overruns in equilibrium. The tradeoff between selecting the lowest cost source and inducing efficient investment effort is explored.

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Article provided by Society for AEF in its journal Annals of Economics and Finance.

Volume (Year): 2 (2001)
Issue (Month): 2 (November)
Pages: 401-414

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Handle: RePEc:cuf:journl:y:2001:v:2:i:2:p:401-414
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  1. Jean Tirole, 1985. "Procurement and Renegotiation," Working papers 362, Massachusetts Institute of Technology (MIT), Department of Economics.
  2. Riordan, Michael H & Sappington, David E M, 1987. "Awarding Monopoly Franchises," American Economic Review, American Economic Association, vol. 77(3), pages 375-87, June.
  3. Anton, James J & Yao, Dennis A, 1992. "Coordination in Split Award Auctions," The Quarterly Journal of Economics, MIT Press, vol. 107(2), pages 681-707, May.
  4. repec:cup:cbooks:9780521447287 is not listed on IDEAS
  5. Lichtenberg, Frank R., 1995. "Economics of defense R&D," Handbook of Defense Economics, in: Keith Hartley & Todd Sandler (ed.), Handbook of Defense Economics, edition 1, volume 1, chapter 15, pages 431-457 Elsevier.
  6. Rogerson, William P, 1990. "Quality vs. Quantity in Military Procurement," American Economic Review, American Economic Association, vol. 80(1), pages 83-92, March.
  7. Lichtenberg, Frank R., 1989. "How elastic is the government's demand for weapons?," Journal of Public Economics, Elsevier, vol. 40(1), pages 57-78, October.
  8. William P. Rogerson, 1994. "Economic Incentives and the Defense Procurement Process," Journal of Economic Perspectives, American Economic Association, vol. 8(4), pages 65-90, Fall.
  9. R. Preston McAfee & John McMillan, 1986. "Bidding for Contracts: A Principal-Agent Analysis," RAND Journal of Economics, The RAND Corporation, vol. 17(3), pages 326-338, Autumn.
  10. Rogerson, William P., 1995. "Incentive models of the defense procurement process," Handbook of Defense Economics, in: Keith Hartley & Todd Sandler (ed.), Handbook of Defense Economics, edition 1, volume 1, chapter 12, pages 309-346 Elsevier.
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