Wild Bids Gambling for Resurrection in Procurement Contracts

Abstract

This paper analyzes the problem of abnormally low tenders in the procurement process. Limited liability causes firms in a bad financial situation to bid more aggressively than good firms in the procurement auction. Therefore, it is more likely that the winning firm is a firm in financial difficulties with a high risk of bankruptcy. The paper analyzes the different regulatory practices to face this problem with a special emphasis on surety bonds used e.g. in the US. We characterize the optimal surety bond and show that it does not coincide with the current US regulation. In particular we show that under a natural assumption the US regulation is too expensive and provides overinsurance to the problem of abnormally low tenders.

Keywords: procurement, bankruptcy, abnormally low tenders, regulation

JEL Classification: L51, H57, D44