Pay for Performance in Procurement

Speaker: Prof Makoto Hanazono

Affiliation: Nagoya University

Location: Level 6 Boardroom (629), Colin Clark Building (#39), St Lucia Campus

Abstract: This paper sheds light on the limitations of “pay-for-performance” in bidding mar-kets with ex post moral hazard. High-powered incentive schemes may lead to worse allocations. We present our analysis in a procurement setting in which potential con-tractors differ both in their costs and levels of wealth and are protected by limited liability. We show first that competitive mechanisms adversely select undercapitalized firms. Second, more powerful incentive mechanisms induce less desirable allocations: the selected contractor is likely to be at the same time less solvent and less efficient. As a result, low-powered incentives in procurement may be optimal. This is consis-tent with the fact, that despite the large social welfare losses arising from inadequate performance by contractors (delays, cost overruns, deficient quality of output) in pro-curement, powerful pay-for-performance mechanisms appear to be rare in reality.