Auctions versus negotiations: the effects of inefficient renegotiation

• DOI: http://doi.org/10.1111/1756-2171.12189
• Date: 01 August 2017
• Author: Fabian Herweg,Klaus M. Schmidt
• Published date: 01 August 2017

RAND Journal of Economics

Vol.48, No. 3, Fall 2017

pp. 647–672

Auctions versus negotiations: the effects

of inefficient renegotiation

Fabian Herweg∗

and

Klaus M. Schmidt∗∗

For the procurement of complex goods, the early exchange of information is important to avoid

costly renegotiation. If the buyer can specify the main characteristics of possible design improve-

ments in a complete contingent contract, scoring auctions implement the efficient allocation. If

this is not feasible, the buyer must choose between a price-only auction (discouraging early in-

formation exchange) and bilateral negotiations with a preselected seller (reducing competition).

Bilateral negotiations are superior if potential design improvements are important, if renegotia-

tion is very costly, and if the buyer’s bargaining position is strong. Moreover, negotiations provide

stronger incentives for sellers to investigate design improvements.

1. Introduction

A company or a government agency that wants to procure a complex project has to decide

which procurement mechanism to use. For complex projects, such as a customized component

in production, a tailor-made software, or an original building, it is often the case that potential

contractors have superior information about possible design options and know better than the

buyer what the optimal design is. In these situations, the early exchange of information is of

crucial importance for using the knowledge and expertise of a contractor before the designs are

complete and production begins.

Two procurement procedures frequently applied in practice are (i) price-only auctions and

(ii) bilateral negotiations. The advantages of auctions are well understood. An auction achieves

low prices by inducing strong competition between bidders, and it safeguards against corruption

and favoritism. For these reasons, the law in most industrialized countries requires that public

∗University of Bayreuth, CESifo, and CEPR; fabian.herweg@uni-bayreuth.de.

∗∗University of Munich, CESifo, and CEPR; klaus.schmidt@lrz.uni-muenchen.de.

Financialsuppor t byDeutsche Forschungsgemeinschaft through SFB-TRR 190 is gratefully acknowledged. Wewould like

to thank the Editor (DavidMar timort), twoanonymous referees, Michael Grubb, Magdalena Helfrich, Thomas Kittsteiner,

TakeshiMurooka, Antonio Rosato, Steve Tadelis, and C´

edric Wasserfor ver y helpful comments and suggestions. Part of

this research was conducted while Herwegvisited University of Technology Sydney,and Herweg would like to thank the

Business School for its hospitality.

C2017, The RAND Corporation. 647

648 / THE RAND JOURNAL OF ECONOMICS

procurement orders have to be awarded by auction if certain thresholds are exceeded.1Private

companies, on the other hand, are more reluctant to use competitiveprocedures to award procure-

ment contracts. For instance, Bajari, McMillan, and Tadelis (2009) report in their data of private

construction contracts in Northern California that 43% have been awarded via negotiations with

a sole supplier and only 18% via open competitive tendering.2They find that auctions perform

poorly and are rarely applied when projects are complex.

In this article, we show that negotiations may outperform auctions because they give better

incentives to sellers to reveal private information about possible design improvements early. Our

model formalizes a trade-off between competition and information exchange. It is built on two

crucial ingredients. First, potential contractors may be aware of a more efficient design than the

buyer. Second, adjusting the design ex post via contract renegotiation is costly and inefficient.

Note that if renegotiation is costless and yields an efficient outcome, there is no problem: the

buyer and the contractor always renegotiate to the efficient design, no matter what the initial

contract specifies. Furthermore, the seller with the best idea for a design improvement is likely

to win the auction. He would gain most from renegotiation, and therefore bid most aggressively.

However, there is substantial evidence that contract renegotiation is often costly and inefficient.

In an empirical analysis of highway procurement contracts in California, Bajari, Houghton, and

Tadelis (2014) estimate that the costs of renegotiation “range from 55 cents to around twodollars

for every dollar in change.” Thus, with costly renegotiation, the early exchange of information is

important.

First, as a benchmark, weshow that if the buyer can fully specify all characteristics of possible

design improvements in a complete contingent contract, then she can use a scoring auction to

achieve early information revelation and strong competition at the same time. However, if the

buyer does not know howpossible design improvements look like and if she cannot describe their

characteristics ex ante, she has to award an incomplete contract that may have to be renegotiated

ex post. In this case, the buyer has to choose between a price-only auction (for a given design)

and contract negotiations with one seller.

In either case, we allowfor a communication stage before the buyer fixes the design she wants

to procure. We show that with a price-only auction, suppliers have no incentives to inform the

buyer about superior designs before the contract is signed. An informed supplier maximizes his

profits by hiding his information, bidding more aggressively, and recouping profits after winning

the contract by revealing a superior design ex post and engaging in contract renegotiation.3In

contrast, if the buyer commits to negotiate with one seller, the selected seller has a strict incentive

to reveal design improvements early.4The intuition is that with negotiations, the parties are in a

bilateral monopoly during their entire relationship. Thus, revealing design improvements early

benefits both parties. In contrast, with an auction, there is a highly competitive environment

1The Agreement on Government Procurement (GPA), which came into effect in 1996 under the auspices of the

WorldTrade Organization, requires transparent, nondiscriminatory,and open competitive tendering for the award of public

procurement orders that exceed certain thresholds. The GPA is a multilateral agreement signed by most industrialized

countries, including the United States and the European Union (Audet, 2002). In the United States, public procurement

is regulated by the Federal Acquisition Regulation in accordance with the GPA. In the European Union, three directives

prescribe the rules for public procurement orders, which are often stricter than the GPArules (Drijber and Stergiou, 2009).

2The remaining contracts have been assigned mostly via an auction among a restricted group of suppliers. Leffler,

Rucker, and Munn (2003) investigate privatecompany sales of timber in North Carolina. They report that roughly 50%

of the contracts are awarded via bilateral negotiation.

3This is in line with the informal argument made by Bajari and Tadelis (2006) in their handbook chapter: “A

supplier has no incentive to offer the procurer advice on how to improve the plans [ . . . ] a supplier would have the

incentive to keep any findings [. . . ] to himself as they offerhim a competitive advantage over his rivals in a competitive

tendering process.”

4In fact, if a buyer negotiates the contract with a selected seller, the two parties typically spend a lot of time

discussing the optimal design of the project before the contract is signed, see Bajari and Tadelis (2006). Thus, there is

less need for costly renegotiation ex post.

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The RAND Corporation 2017.