OPTIMAL COST OVERRUNS: PROCUREMENT AUCTIONS WITH RENEGOTIATION

• Published date: 01 November 2018
• Author: Marco A. Schwarz,Fabian Herweg
• DOI: http://doi.org/10.1111/iere.12327
• Date: 01 November 2018

INTERNATIONAL ECONOMIC REVIEW

Vol. 59, No. 4, November 2018 DOI: 10.1111/iere.12327

OPTIMAL COST OVERRUNS: PROCUREMENT AUCTIONS

WITH RENEGOTIATION∗

BYFABIAN HERWEG AND MARCO A. SCHWARZ1

University of Bayreuth, CESifo, Germany, CEPR, UK; University of Innsbruck, Austria

Cost overrun is ubiquitous in public procurement. We argue that this can be the result of a constrained

optimal award procedure: The procurer awards the contract via a price-only auction and cannot commit not to

renegotiate. If cost differences are more pronounced for a fancy than a standard design, it is optimal to fix the

standard design ex ante. If renegotiation takes place and the fancy design has higher production costs or the

contractor’s bargaining position is strong, the final price exceeds the initial price. Moreover, the procurer cannot

benefit from using a scoring auction.

1. INTRODUCTION

Renegotiation of procurement contracts awarded by public authorities is ubiquitous. The

initial contract is awarded via competitive tendering; that is, via an auction. The terms of the

initial contract, however, are often subject to renegotiation, with the result that the ultimate

price is (by far) higher than the price that the parties initially agreed upon. Prominent recent

examples of public procurement projects that are by far more expensive than initially planned

are the Elbphilharmonie, a concert hall in Hamburg, the Big Dig, a highway artery in Boston,

and the North–South metro line in Amsterdam.2What is often considered as the most severe

case of a cost overrun in modern construction history is the Sydney Opera House.3The project

was completed 10 years late at a price of 14.6 times the initial price.4During the construction of

the Sydney Opera House, plenty of design changes had taken place. For instance, the design of

the roof has been changed from a relatively flat roof to the fancy ribbed ellipsoidal roof, which

∗Manuscript received July 2016; revised October 2017.

1We thank the editor, Masaki Aoyagi, three anonymous referees, Mikhail Anufriev, Alessandro De Chiara, Dominik

Fischer, Jacob Goeree, Heiko Karle, Laurent Lamy, Laurent Linnemer, Johannes Maier, Antonio Rosato, Klaus

M. Schmidt, Johannes Schneider, Heiner Schumacher, and Christoph Schwaiger for many helpful comments and

suggestions. We would also like to thank the seminar and conference participants at EARIE Maastricht, KU Leuven,

UC Louvain-la-Neuve, DICE D¨

usseldorf, Mannheim University, Carlos III de Madrid, Frankfurt School of Finance

& Management, Theoretischer Ausschuss at Basel, X-CREST Paris, University of Bern, University of Munich, and

University of Technology Sydney. Part of this research was conducted while the first author visited the University of

Technology Sydney, and Fabian would like to thank the Business School for its great hospitality. Financial support from

the Deutsche Forschungsgemeinschaft through SFB/TR 15 and CRC/TRR 190 and from the Austrian Science Fund

(SFB F63) are gratefully acknowledged. Please address correspondence to: Fabian Herweg, University of Bayreuth,

Faculty of Law, Business and Economics, International Competition Policy, Universitaetsstr. 30 95447 Bayreuth,

Germany. E-mail: fabian.herweg@uni-bayreuth.de.

2Regarding the Elbphilharmonie, the accepted offer from the underwriting group in 2006 was 241 million euro. The

final price at the handover of keys in 2016 was 789 million euro (Fiedler and Schuster, 2016). For the Amsterdam metro

line, the initial budget was set at 1.46 billion euro in 2002 but the costs had risen to 3.1 billion euro in 2009. Recent

estimates suggest that it will be completed in 2017 (Chang et al., 2016). For the Boston highway artery, the ultimate

price exceeded the initial price by 1.6 billion U.S. dollars (Bajari et al., 2014).

3We define as cost overrun the difference between the final price and the initial price at which the procurement

order has been awarded.

4When controlling for inflation, the cost overrun reduces to a factor of 7.5 (Newton et al., 2014).

1995

C

(2018) The Authors. International Economic Review published by Wiley Periodicals, Inc. on behalf of Economics

Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research

Association

This is an open access article under the terms of the Creative Commons Attribution License, which permits use,

distribution and reproduction in any medium, provided the original work is properly cited.

1996 HERWEG AND SCHWARZ

increased the cost for the roof by 65%. This and other changes that arguably made the Sydney

Opera House more complex are responsible for a part of its cost overrun.5

Next to casual observations, empirical studies document that the prices typically increase

through renegotiation.6According to public opinion, these cost overruns are a sign of inefficient

project management by bureaucrats or of strategizing politicians and thus a waste of taxpayers’

money. In contrast to this widespread public opinion, we argue that these seemingly inefficient

cost overruns can be the result of a constrained optimal award procedure that minimizes the

expected final price for the procurer.

In our model, a procurer needs an indivisible good or service, which can take one of two

designs, that is, a standard (low quality) or a “fancy” (high quality) design (a bridge with

two or three traffic lanes). The good can be delivered by several suppliers who may differ in

their privately known production costs. Moreover, the ex post efficient design depends on the

contractor’s production cost, that is, on the cost type of the supplier who has been awarded

the contract. Initially, the procurer runs an auction to allocate the contract. Importantly, the

contract specified by the auction is a specific performance contract that can be enforced by

courts. First, we assume that the procurer can collect bids only on prices and thus has to select

one particular design of the good. More precisely, the procurement contract for the given

design is awarded to one supplier via a standard auction, for example, a second-price sealed-bid

auction. The design specified in the initial contract may turn out to be inefficient, given the cost

type of the contractor. In this case, we assume that the parties engage in Coasian bargaining

and implement the efficient design ex post. Renegotiation is expected by the suppliers and

thus incorporated in their bidding behavior. The rent the contractor (the supplier who won the

auction) receives depends on his cost advantage compared to the second lowest bidder with

regard to the initial design. We assume that cost differences are more pronounced for the fancy

design than for the standard one. Under this assumption, it is optimal for the procurer to fix

the standard design ex ante because this enhances competition in the initial auction. In other

words, when commitment not to renegotiate is not feasible, it is optimal for the procurer to

choose the standard design ex ante and to potentially renegotiate to the fancy design ex post. If

the cost for producing the fancy design is higher or if the contractor’s bargaining power is not

too weak, the final (renegotiation) price exceeds the initial price, i.e., a cost overrun occurs.

An important feature of our model is that the outcome is always efficient. The supplier who

can deliver the ex post efficient design at the lowest cost wins the auction. He benefits most

from contract renegotiation and thus bids most aggressively. This implies that the unique goal

of the procurer is rent extraction, i.e., choosing the initial design such that the expected final

price—for the overall efficient design delivered by the most efficient supplier—is minimized. In

other words, the procurer does not face a rent extraction versus efficiency trade-off.

Due to the assumption of Coasian bargaining ex post, the ex post outcome is always efficient

in our baseline model. In two extensions, we augment the baseline model and allow for renego-

tiation failure. First, we consider the situation where contract renegotiation takes place under

asymmetric information. Focusing on a simplified model with only two cost types, we show that

the type is always revealed via the bid. The procurer optimally specifies the standard design

ex ante, and contract renegotiation typically leads to an upward price adjustment. Second, we

analyze what happens when there is an exogenous risk that the renegotiation breaks down and

the parties are stuck with the initial contract. If this risk is rather low, it is still optimal to choose

the standard design ex ante. As the risk becomes larger, taking into account the situation when

renegotiation fails becomes more important, so the optimal initial design is more likely to be

5See Newton et al. (2014) and Drew (1999) for more detailed discussions of the construction and cost increases of

the Sydney Opera House.

6Substantial price increases resulting from contract renegotiation are reported by Decarolis (2014) for Italian pro-

curement contracts and by Bajari et al. (2014) for Californian procurement contracts. German procurement contracts

and their cost increases are listed by Fiedler and Schuster (2016). They also report that some projects perform excep-

tionally well. For instance, the Chemikum, a building of the University of Erlangen-Nuremberg, was completed a year

earlier than planned and at a cost of only 80 million euro instead of the planned 140 million euro.