Teaching an Old Dog a New Trick: Reserve Price and Unverifiable Quality in Repeated Procurement

Abstract

In procurement markets, unverifiable quality provision may be obtained either by direct negotiation or by competitive processes which discriminate firms on the basis of their past performance. However, discrimination is not allowed in many institutional contexts. We show that a non-discriminatory competitive process with a reserve price may allow the buyer to yield an efficient allocation of the contract and to implement the level of quality desired by the buyer. Quality enforcement arises out of a relational contract whereby the buyer threatens to set a 'low' reserve price in future competitive tendering processes if any contractor fails to provide the required quality. We study an infinitely repeated procurement model with many firms and one buyer imperfectly informed on the firms' cost, in which, in each period, the buyer runs a standard low-price auction with reserve price. We study the cases of players using grim trigger strategies, analysing both the case of a committed and uncommitted buyer. We find that a competitive process with reserve price is able to elicit the desired level of unverifiable quality provided that the buyer's valuation of the project is not too high and the value of quality is not too low; under these conditions, the buyer can credibly threaten the firms to set, in case a contractor fails to deliver the required quality level, a reserve price so low that no firm is willing to participate to the tender. A committed buyer can elicit the desired quality level for a wider range of preference parameters.

Keywords: public procurement, relational contracts, unveriable quality, reserve price

JEL Classification: H57, D44