Procurement and Accidents: The Liability Curse

We analyze a procurement setting in which the sponsor intends to allocate a project that involves some risk of external harm. An ex post regulatory regime gives the winning bidder incentives to invest in care. Limited liability induces less solvent firms to bid more aggressively in the auction, so competitive mechanisms adversely select undercapitalized firms. We present the liability curse in competitive procurement settings: tougher ex post regulations (such as increases in liability standards) may lead to worse allocations, so firms that both are less capitalized and have higher costs are more likely to win.

We present the implications of the liability curse for precautions and bankruptcy risk and explore several avenues to improve the final allocation and to reduce the probability of accidents: use of moderate standards, limited competition in the bidding process, surety bonds, and performance bonuses.