Incentive Contracts, Adverse Selection, and Risk Transfer: Evidence from Procurement

Abstract

Multi-attribute auctions, designed to address multi-dimensional preference, make a good case study where incentive provisions interact with competition. By studying "Cost Time" highway procurement that aims to incentivize timely project delivery, we show that awarding incentive contracts by bidding mechanisms can yield sub-optimal outcomes. Our theory demonstrates that bidders, facing high-powered incentives and production uncertainty, optimally skew their time bids while transferring production risk to buying agencies. This gaming behavior leads to adverse selection and efficiency loss, in that a less-efficient bidder can outbid the efficient bidder due to the misalignment between bidder types and the auction rule that determines winners. We estimate our model using data from the California Department of Transportation and find that 18% of auctions are allocated to inefficient bidders. Counterfactual analyses suggest that procurement schemes with lower incentives can yield less mis-allocation with lower production costs and less buyer budget pressure.