Managing Project Failure Risk through Contingent Contracts in Procurement Auctions

Decision Analysis, Vol. 7, No. 1, pp. 23-39, 2010

McCombs Research Paper Series No. IROM-14-09

38 Pages Posted: 9 Jun 2009 Last revised: 27 Oct 2015

See all articles by Jianqing Chen

Jianqing Chen

The University of Texas at Dallas, Jindal School of Management

Lizhen Xu

Georgia Institute of Technology - Scheller College of Business

Andrew B. Whinston

University of Texas at Austin - Department of Information, Risk and Operations Management

Date Written: April 20, 2009

Abstract

Procurement auctions are sometimes plagued with a chosen supplier's failing to accomplish a project successfully. The risk of project failure is considerable, especially when the buyer has inadequate information about suppliers ex ante and the project can only be evaluated at the end. To manage such uncertainty, a model of competitive procurement and contracting for a project is presented in this paper. We study a setting in which suppliers differ in both the costs to fulfill the project and the types reflecting their success probabilities. To screen suppliers, the buyer invites suppliers to specify a two-dimensional bid composed of the proposed cost and a penalty payment if the delivered project fails to meet the requirements. We find that a quasi-linear scoring rule can effectively separate suppliers regarding their types. We then study the efficient and optimal design of the scoring rule. The efficient design internalizes the inferred information on suppliers' type and essentially ranks suppliers based on the expected total cost to the buyer. In the optimal design, the buyer may or may not under-reward suppliers' high success probability, depending on the balance between suppliers' success probabilities and the associated cost distributions. Interestingly, it is always optimal for the buyer to possibly award the project to suppliers with low success probability in order to promote the competition, even when the difference in suppliers' success probabilities is huge. We show that, compared to standard auctions, the procurement auctions with contingent contracts can significantly improve both social welfare and the buyer's payoff.

Keywords: Procurement auctions, Contingent contract, Scoring rule

Suggested Citation

Chen, Jianqing and Xu, Lizhen and Whinston, Andrew B., Managing Project Failure Risk through Contingent Contracts in Procurement Auctions (April 20, 2009). Decision Analysis, Vol. 7, No. 1, pp. 23-39, 2010; McCombs Research Paper Series No. IROM-14-09. Available at SSRN: https://ssrn.com/abstract=1415391

Jianqing Chen (Contact Author)

The University of Texas at Dallas, Jindal School of Management ( email )

800 West Campbell Road
Richardson, TX 75080
United States

Lizhen Xu

Georgia Institute of Technology - Scheller College of Business ( email )

United States
404-894-4380 (Phone)
404-894-6030 (Fax)

Andrew B. Whinston

University of Texas at Austin - Department of Information, Risk and Operations Management ( email )

CBA 5.202
Austin, TX 78712
United States
512-471-8879 (Phone)

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