On cost overruns in procurement

Abstract

We consider auctions/tenders for the procurement of goods and services in the setting where the potential contractors face ex-post risks that may lead to cost overruns. The contractors have limited access to credit and are protected by limited liability. We identify the trade-offs that the procurement agency faces in such settings and show that the procuring agency minimizing the expected costs of the project greatly benefits by allocating a share of the award ex-ante, at the time of contracting, with the remainder due ex-post, after the completion of the project.