Working Paper: NBER ID: w25547
Authors: Nicholas Ryan
Abstract: Weak contract enforcement may reduce the efficiency of investment in developing countries. I study how contract enforcement affects efficiency in procurement auctions for the largest power projects in India. I gather data on bidding and ex post contract renegotiation and find that the renegotiation of contracts in response to cost shocks is widespread, despite that bidders are allowed to index their bids to future costs like the price of coal. Connected firms choose to index less of the value of their bids to coal prices and, through this strategy, expose themselves to cost shocks to induce renegotiation. I use a structural model of bidding in a scoring auction to characterize equilibrium bidding when bidders are heterogeneous both in cost and in the payments they expect after renegotiation. The model estimates show that bidders offer power below cost due to the expected value of later renegotiation. The model is used to simulate bidding and efficiency with strict contract enforcement. Contract enforcement is found to be pro-competitive. With no renegotiation, equilibrium bids would rise to cover cost, but markups relative to total contract value fall sharply. Production costs decline, due to projects being allocated to lower-cost bidders over those who expect larger payments in renegotiation.
Keywords: contract enforcement; investment efficiency; procurement auctions; India; political connections
JEL Codes: D44; K12; L94; O14; Q41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Political connections (D72) | less indexing of bids to coal prices (L71) |
| less indexing of bids to coal prices (L71) | exposure to cost shocks (E30) |
| exposure to cost shocks (E30) | contract renegotiation (L14) |
| contract enforcement (K12) | pro-competitive effects (L49) |
| strict contract enforcement (P14) | bids rise to cover costs (D44) |
| bids rise to cover costs (D44) | decrease in production costs (D24) |
| strict contract enforcement (P14) | increased efficiency (D61) |
| Weak contract enforcement (D86) | lower competitive bidding (D44) |
| Weak contract enforcement (D86) | higher production costs (D24) |
| anticipated renegotiation payments (J33) | bidders bid below costs (D44) |
| Cost shocks (D24) | likelihood of contract renegotiation (L14) |