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 bankruptcy costs. When …nancial soundness is not perfectly observable, we show that incentive compatibility implies that …nancially less sound contractors are selected with higher probability in any feasible mechanism. Informational rents are associated with unsound …nancial situations. By selecting the …nancially weakest contractor, stronger price competition (auctions) may not only increase the probability of default but also expected rents. Thus, weak conditions are su¢ cient for auctions to be suboptimal. In particular, we show that pooling …rms with higher assets may reduce the cost of procurement even when default is costless for the sponsor. Keywords: Procurement, limited liability, bankruptcy. JEL classi…cation numbers: L51, H57, D44. We thank participants of the Barcelona Jocs seminar for helpful comments and suggestions. All authors acknowledge the support of the Barcelona GSE Research and the government of Catalonia. Hauk acknowledges …nancial support from the CICYT project n. SEJ2006-01717 yInstitut d’Anàlisi Econòmica CSIC, Campus UAB, 08193 Bellaterra, e-mail: [email protected] zDepartment of Economics and Business, Universitat Pompeu Fabra, Ramon Trias Fargas 23-27, 08005 Barcelona, e-mail: [email protected] xInstitut d’Anàlisi Econòmica CSIC, Campus UAB, 08193 Bellaterra, e-mail: [email protected]