Procurement Mechanisms with Post-Auction Pre-Award Cost-reduction Investigations

Abstract

A buyer seeking to outsource production may be able to find ways to reduce a potential supplier's cost, e.g., by suggesting improvements to the supplier's proposed production methods. We study how a buyer could use such "cost-reduction investigations" by proposing a three-step supplier selection mechanism: First, each of several potential suppliers submits a price bid for a contract. Second, for each potential supplier, the buyer can exert an effort to see if she can identify how the supplier could reduce his cost to perform the contract; the understanding is that if savings are found, they are passed on to the buyer if the supplier is awarded the contract. Third, the buyer awards the contract to whichever supplier has the lowest updated bid (the supplier's initial bid price minus any cost-reduction the buyer was able to identify for that supplier). For this proposed process, we characterize how the buyer's decision on which suppliers to investigate cost reductions for in step 2 is affected by the aggressiveness of the suppliers' bids in step 1. We show that even if the buyer does not share the cost savings she identifies in step 2, ex ante symmetric suppliers are actually better off (ex ante) in our proposed mechanism than in a setting without such cost-reduction investigations, resulting in a win-win for the buyer and suppliers. When suppliers' cost and cost-reduction distributions become very heterogeneous, the win-win situation may no longer hold, but every supplier still has an incentive to allow the buyer to investigate him in step 2 because it increases his chance of winning the contract. Using an optimal mechanism analysis, our numerical studies show that our proposed Bid-Investigate-Award mechanism helps the buyer achieve near-optimal performance, despite its simplicity.

Keywords: Procurement, Cost-Reduction Investigation, Win-Win, Mechanism Design, First-Price Sealed-Bid Auction, Optimal Mechanism

JEL Classification: C61, C73, D44