FEEM working papers "Note di lavoro" series
2012 .045

Procurement with Unenforceable Contract Time and the Law of Liquidated Damages


Authors: Cesare Dosi, Michele Moretto
Series: Economy and Society
Editor: Giuseppe Sammarco
Keywords: Public Procurement, Fixed-Price Contracts, Cost Uncertainty, Time Overruns, Liquidated Damages, Real Options
JEL n.: C61, D44, D86, K12

Abstract

Time overruns are common in public works and are not confined to inherently complex tasks. One explanation advanced in this paper is that bidders can undergo unpredictable changes in production costs which generate an option value of waiting. By exploiting the real-option approach, we examine how the inability to force sellers to meet the contract time influences their bidding behaviour, and how this can ultimately affect the parties’ expected payoffs. Further, we examine the outcome of the bidding process when legal rules prevent the promisee from contracting for damage measures which would grant more than her lost expectation. We show that when the pre-agreed compensatory payments prove insufficient to discourage delayed orders, setting a liquidated damages clause would not lead to a Pareto superior outcome with respect to the no-damage-for delay condition. While such a clause would increase the seller’s expected payoff, the buyer’s expected payoff is lower than when the contract does not provide for any compensation for late-delivery.

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