Free-Riding in Procurement Design

Abstract

Despite low-powered contracts do not provide proper incentives to reduce cost, empirical studies show that they are quite pervasive in public and private procurement. This paper demonstrates that low-powered contracts arise in equilibrium due to a free-riding problem in procurement design when the contractor (agent) has economies of scale/scope working for different buyers (principals). A buyer, who individually offers a procurement contract to the contractor, does not fully internalize that eliciting higher-powered incentives provides cost reduction in the contractor's activities, benefiting other buyers. However, he internalizes all the cost associated to such incentive scheme. As a result, buyers offer lower-powered contracts than what would be designed by cooperative buyers. Differently from other papers in the literature, this paper predicts that the higher are the contractor's benefits from economies of scope/scale; the lower is the power of the procurement contracts. In addition, it shows that laws which oblige buyers to award fixed-price contracts can be welfare-enhancing.