Public Procurement Under Limited Liability

Public procurement faces the risk that the contractor goes bankrupt before the completion of the work. The possibility to declare bankruptcy makes the contractors behave more aggressively.This leads to abnormally low tenders and to the break-down of revenue equivalence. Upon this result we investigate frequently used public procurement methods that were designed to avoid the bankruptcy of the winning contractor. We show that the averagebid-method or methods that exclude the lowest offer fare quite badly. We also show that — in contrast to standard auction theory — multi-sourcing, rationing and other means to soften competition may fare better than a standard auction.
[JEL-Classification: D44, D45, D82, G33, H57]

The Authors would like to thank Esther Hauk, seminar participants at the CESifo area conference on Industrial Organization in Munich, at the theory seminar in Berlin and the seminars at the RSSS and the ANU in Canberra for helpful comments and suggestions. Engel gratefully acknowledges financial support from the German Academic Exchange Service (DAAD) under grant D/04/30600.