Procurement under public scrutiny: auctions versus negotiations

• DOI: http://doi.org/10.1111/1756-2171.12159
• Author: Achim Wambach,Vitali Gretschko
• Date: 01 November 2016
• Published date: 01 November 2016

RAND Journal of Economics

Vol.47, No. 4, Winter 2016

pp. 914–934

Procurement under public scrutiny:

auctions versus negotiations

Vitali Gretschko∗

and

Achim Wambach∗

We compare two commonly used mechanisms in public procurement: auctions and negotiations.

The execution of the procurement mechanism is delegated to an agent of the buyer. The agent

has private information about the buyer’s preferences and may collude with one of the sellers.

Weprovide a general characterizationof both mechanisms based on public scrutiny requirements

and show—contrary to conventional wisdom—that an intransparent negotiation always yields

higher social surplus than a transparent auction. Moreover, there exists a lower bound on the

number of sellers such that the negotiation also generates a higher buyer surplus.

1. Introduction

Auctions are believed to be transparent mechanisms and thus less prone to favoritism than

intransparent negotiations. For instance, Paul Klemperer (2000) argues that “. . . allocation by

bureaucrats leads to the perception—if not the reality—of favoritism and corruption. In fact some

governments have probably chosen beauty contests [over auctions] precisely because they create

conditions for favoring “national champions” overforeign competitors. This is unlikely to benefit

consumers and taxpayers.”1

∗Center for European Economic Research (ZEW) Mannheim; gretschko@zew.de, wambach@zew.de.

We would like to thank Paul Heidhues, Johannes H¨

orner, Philippe Jehiel, Elena Katok, David Martimort (Editor),

Alexander Rasch, and the participants of the seminars at DICE 2015, Paris School of Economics 2014, Penn State 2012,

YaleUniversity 2012, and of the workshop of the DFG research unit Design and Behavior 2013 in Cologne for helpful

comments and discussions. Finally,we thank two anonymous referees for detailed and helpful comments that haveg reatly

improved this article. All remaining errors are our own. Financial support from the German Science Foundation (DFG)

through the research unit Design and Behavior and the Fulbright Commission is gratefully acknowledged. Substantial

parts of this article were written when Gretschko stayedat YaleUniversity in 2011/2012. The author thanks the department

of economics for its hospitality.

1More recently,Subramanian (2010) states that “[a]uctions are more transparent processes than private negotiations,

so if transparency is important, an auction is better. This is the reason that most public procurement contracts [. . .] are

done through auctions, particularly when the government is looking to defuse criticisms of corruption or favoritism.”

Moreover,Wolf (2000) argues that “it [the auction] is the fairest [mechanism] because it ensures that the economic value

goes to the community, whileeliminating the favoritism and corruption inherent in bureaucratic discretion.”

914 C2016, The RAND Corporation.

GRETSCHKO AND WAMBACH / 915

The perception that auctions are more transparent than negotiations stems from the fact that

auctions are executed publicly, whereas negotiations are conducted outside the public eye.Hence,

in an auction, all relevant parameters and rules have to be defined before the bidders submit

their offers and it is apparent whether the implemented procedures have been followed. Contrary

to that, in a negotiation, it is impossible to reconstruct the decision process and only the final

decision becomes public.

However, public scrutiny does not imply that auctions are favoritismproof, as the parameters

and procedures of an auction may be chosen in a way that benefits one of the sellers before the

auction has even started. Moreover, even though a negotiation is conducted outside the public

eye, the final outcome of the process has to be justified to the public after all offers have been

collected. Thus, some public scrutiny cannot be avoided in a negotiation.2

We consider a procurement setting with sellers that are horizontally differentiated with

respect to the specification of the procured project. Buyer surplus depends not only on the final

price but also on the implemented specification. The buyer has to delegate the execution of the

procurement process to an agent who privately observes the specification preference of the buyer

and colludes with one—exogenously chosen—seller.3

We start our analysis by deriving the buyer-surplus and the social-surplus optimal mech-

anisms. The optimal mechanisms have two features that are worth stressing. First, the winning

probability of the preferred seller is independent of the report of the agent concerning the buyers’

preferred specification. That is, the agent has no discretion in the decision whether the preferred

seller receives the object. Second, whenever the preferred seller fails to win the object, the agent

has full discretion on how to allocate the object among the honest sellers. Both properties ensure

that the agent reports the specification preference of the buyer truthfully and that the allocation

among the honest sellers is optimal. The main insight from the analysis of the optimal mechanism

is that when evaluating any mechanism in the presence of favoritism, the performance of this

mechanism will depend on the winning probability of the preferred seller and on whether the

allocation among the honest sellers will be distorted.

Buyers are often not able to fine-tune the optimal mechanism to the environment and thus

are forced to use cruder measures to curb favoritism. A typical reaction to the threat of favoritism

is to publicly scrutinize the decisions of the agent. Thus, we turn our attention from a normative

analysis of the optimal mechanism to a positive analysis of the public scrutiny requirements of

two commonly used procurement mechanisms—auctions and negotiations. We argue that in an

auction, public scrutiny is imposed before the agent collects the offers of the sellers, whereas in

the negotiation, public scrutiny is imposed after collecting the offers. Hence, publicscr utinyin an

auction restricts the choice of the process (process scrutiny), whereas in the negotiation, public

scrutiny merely places restrictions on the final decision of the agent (outcome scrutiny). Thus,

in the auction, the agent is then restricted to the ex ante optimal decision, given the information

available to th e buyer.4In the negotiation, outcome scrutiny implies that the agent is restricted

to the ex post optimal decision, given the information of the buyer. Given those restrictions, we

derive the auction and the negotiation that maximize the joint surplus of the agent and the favorite

2This argument carries overto private auctions and negotiations. Even though private procurement is not conducted

publicly,the managers still have to report to the shareholders of the procuring company.

3The assumption that the agent colludes with one specific seller resembles many real-life situations in public

procurement. For example, Laffont and Tirole (1991) point out that “[t]here has been much concern that the auction

designer may prefer or collude with a specific buyer. And indeed most military or governmental markets’ acquisition

regulations go to a great length to impose rules aimed at curbing favoritism. Similarly,the European Economic Comission,

alarmed by the abnormally large percentage (above95% in most countries) of government contracts awarded to domestic

firms is trying to design rules that would foster fairer competition between domestic and foreign suppliers and would fit

better than recent experience with the aim of fully opening borders.”

4If the buyer is concerned with social surplus, the agent has to implement the social-surplus optimal auction given

his announcement of the buyer’s preferred specification. If the buyer is concerned with his own surplus, the agent has to

implement the buyer-surplus optimal auction given his announcement of the buyer’s preferred specification.

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