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Limited Liability and Mechanism Design in Procurement

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  • Esther Hauk
  • Juan-José Ganuza
  • Roberto Burguet

Abstract

In the presence of cost uncertainty, limited liability introduces the possibility of default in procurement with its associated bankruptcy 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 sufficient for auctions to be supoptimal. In particular, we show that pooling firms with higher assets may reduce the cost of procurement even when default is costless for the sponsor.

Suggested Citation

  • Esther Hauk & Juan-José Ganuza & Roberto Burguet, 2015. "Limited Liability and Mechanism Design in Procurement," Working Papers 383, Barcelona School of Economics.
  • Handle: RePEc:bge:wpaper:383
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    References listed on IDEAS

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    1. Francesco Decarolis, 2009. "When the highest bidder loses the auction: theory and evidence from public procurement," Temi di discussione (Economic working papers) 717, Bank of Italy, Economic Research and International Relations Area.
    2. Aleix Calveras & Juan-Jose Ganuza & Esther Hauk, 2004. "Wild Bids. Gambling for Resurrection in Procurement Contracts," Journal of Regulatory Economics, Springer, vol. 26(1), pages 41-68, July.
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    6. Waehrer Keith, 1995. "A Model of Auction Contracts with Liquidated Damages," Journal of Economic Theory, Elsevier, vol. 67(2), pages 531-555, December.
    7. 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.
    8. Roger B. Myerson, 1981. "Optimal Auction Design," Mathematics of Operations Research, INFORMS, vol. 6(1), pages 58-73, February.
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    More about this item

    Keywords

    limited liability; Procurement; bankruptcy;
    All these keywords.

    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, Pricing, and Design - - - Auctions

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