Optimal Auctions of Procurement Contracts

Abstract

We consider tenders/auctions for the procurement of items that do not exist at the time of the tender. The cost of production is subject to ex-post shocks, i.e. cost overruns, which cannot be contracted away or insured at the time of tender. The contractors may default due to the cost overruns once the project is underway. We consider a simple contract that specifies the payment in case of default and the award that is paid upon successful project completion. This contract is allocated at the tender and the award part is determined by competitive bidding. We characterize bidding behaviour of contractors in standard tenders and derive the implications for the buyer’s expected cost minimization.