SFB 303 Discussion Paper No. A-481

Author: Bös, Dieter, and Christoph Lülfesmann
Title: Holdups, Quality Choice, and the Achilles' Heel in Government Contracting
Abstract: We investigate a long-term trade relationship in an incomplete contracts framework, and compare the equilibrium outcomes in public procurement (welfare-maximizing buyer) and private procurement (profit-maximizing buyer). There exist multiple trading oppotunities which differ in benefits and production costs, but are indistinguishable for the court. Moreover, the seller can make relationship-specific investments to decrease the expected production costs of a high quality project, the 'innovation'. Given a contract-specific environment under which the optimal long-term arrangement is an at-will contract, a first-best result can always attained in private procurement. In contrast, we show that public procurement may lead to suboptimal investments of the supplier. The government's weak ex-post individual rationality constraint turns out to be its Achilles' Heel: equilibrium trade prices differ in public and private procurement, although ex-post efficient trade is realized in both regimes. Accordingly, and in contrast to the literature, the superiority of private contracting does not hinge upon a trade off between allocative and productive effiency. The article argues for a splitting-up of government institutions, investigates option contracting, and shows that effiency is restored if the court can distinguish between both project versions.
Keywords: Procurement, Incomplete Contracts, Governance Structure
JEL-Classification-Number: D23, K12, L23
Creation-Date: December 3, 1996
URL: ../1996/a/bonnsfa481.pdf

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