Optimal procurement mechanisms: bidding on price and damages for breach

Abstract

We study the optimal procurement mechanism when contract breach and abandoning a project may be efficient, either because of completion costs higher than anticipated or because of new and more lucrative opportunities for the contractor. When contractors have private information about their costs, the procurer finds it optimal to set damages above expectation damages. There is a lock-in effect, or status quo bias; the agent that has won the award will complete the project even in situations when it would be efficient to abandon it. If the cost types of all agents are above a threshold, the optimal bidding procedure assigns the project by lottery. The optimal mechanism cannot be implemented by standard auction formats. However, the larger the number of agents bidding for the project, the closer auctions with a liquidated damage clause approximate the optimal mechanism.