The adverse effects of renegotiation in procurement auctions with endogenous liability

Abstract

We study the effects of the possibility of forming spin-off companies in procurement auctions with renegotiation in a common cost environment. Specifically, we report game theoretic predictions for this setting, which we then test using a laboratory experiment. We focus our analysis on the impact of these spin-off companies on seller bidding strategies and buyer renegotiation behavior. Our data show that sellers are more aggressive during bidding and renegotiation when it is possible to set up a spin-off company that will not assume the liability from a failed contract. As a result, procurer surplus decreases substantially. We observe greater harm to buyer surplus from renegotiation than previously documented in the literature. We associate seller aggressiveness with an increase in the number of insolvencies due to spin-offs. This finding suggests that procurers should exercise great caution when using renegotiation to avoid large surplus losses, because spin-offs may be widely used in practice.