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Limited Liability and Mechanism Design in Procurement

In the presence of cost uncertainty, limited liability introduces the possibility of default in procurement with its associated bank-ruptcy costs. When financial soundness is not perfectly observable, we show that incentive compatibility implies that financially less sound contractors are selected with higher probability in any feasible mechanism. Informational rents are associated with unsound financial situations. By selecting the financially weakest contractor, stronger price competition (auctions) may not only increase the probability of default but also expected rents. Thus, weak conditions are suffcient for auctions to be suboptimal. In particular, we show that pooling firms with higher assets may reduce the cost of procurement even when default is costless for the sponsor.

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Paper provided by Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC) in its series UFAE and IAE Working Papers with number 767.09.

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Length: 31
Date of creation: 20 Apr 2009
Date of revision:
Handle: RePEc:aub:autbar:767.09
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  1. Francesco Decarolis, 2009. "When the Highest Bidder Loses the Auction: Theory and Evidence from Public Procurement," 2009 Meeting Papers 130, Society for Economic Dynamics.
  2. Waehrer Keith, 1995. "A Model of Auction Contracts with Liquidated Damages," Journal of Economic Theory, Elsevier, vol. 67(2), pages 531-555, December.
  3. Simon Board, 2007. "Bidding into the Red: A Model of Post-Auction Bankruptcy," Journal of Finance, American Finance Association, vol. 62(6), pages 2695-2723, December.
  4. Roberto Burguet & Juan-José Ganuza & Esther Hauk, 2009. "Limited Liability and Mechanism Design in Procurement," Working Papers 383, Barcelona Graduate School of Economics.
  5. 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.
  6. Zheng, Charles Zhoucheng, 2001. "High Bids and Broke Winners," Staff General Research Papers 12665, Iowa State University, Department of Economics.
  7. Andreas R. Engel & Achim Wambach, 2006. "Public Procurement Under Limited Liability," Rivista di Politica Economica, SIPI Spa, vol. 96(1), pages 13-40, January-F.
  8. Sarah Parlane, 2003. "Procurement Contracts under Limited Liability," The Economic and Social Review, Economic and Social Studies, vol. 34(1), pages 1–21.
  9. Alejandro M. Manelli & Daniel R. Vincent, 1992. "Optimal Procurement Mechanisms," Discussion Papers 999, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  10. White, Michelle J, 1989. "The Corporate Bankruptcy Decision," Journal of Economic Perspectives, American Economic Association, vol. 3(2), pages 129-51, Spring.
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