A Game of Settlements in Public Contracts

The paper considers a public authority wishing to carry out a major public project. As a result of competitive bidding the project is assigned to the firm with the lowest bid. The cost of the project is uncertain in the sense that it can be low or high. After the bidding process the firm observes the true cost, while the government remains uninformed. After learning about the true cost, the firm can start to renegotiate the contract by proposing an increase of the price. Such an increase is only justified in case costs are high. If the government rejects the new price proposal, a law suit follows. This situation is modeled as a signaling game. If the prior probability of the costs being low is low (high), a pooling (separating) equilibrium occurs. In the pooling equilibrium the government always accepts the firm's proposal. In the separating equilibrium the government can apply a mixed strategy when costs are high. Then it goes to court with a certain probability. Compared to a pure strategy, the mixed strategy has the advantage that legal costs are lower. In our economic analysis we compare the American and the English rule for sharing the litigation expenses. A main result is that under the American rule the legal expenses are lower and welfare is higher in the mixed strategy equilibrium. We also study the importance of the firm's commitment to its new price proposal