On Optimal Competitive Contracting

We present an example of risk neutral bid-taker and bidders in which the bid-taker obtains a greater expected revenue from auctioning an inefficient contract than from auctioning an efficient contract. This occurs because in going from the efficient contract to an inefficient (but almost efficient) contract, the winning bidder's expected profit decreases faster than the value of the output produced under the contract (net of production costs) decreases. Therefore, the bid-taker's expected revenue—the value of the output less the winning bidder's expected profit—increases.

The competitive letting of a contract introduces a factor not present when somehow letting a contract noncompetitively. In particular, changing the contract not only affects the efficiency of the contract, but also affects the amount of the contract's value that will be captured by the contract winner as profit. Therefore, for competitively let contracts, the optimal contract for the bid-taker to offer turns out less efficient than can be explained solely by any benefits from risk sharing.