Sequential procurement auctions and their effect on investment decisions

• Author: Nicolás Figueroa,Gonzalo Cisternas
• Date: 01 October 2015
• DOI: http://doi.org/10.1111/1756-2171.12112
• Published date: 01 October 2015

RAND Journal of Economics

Vol.46, No. 4, Winter 2015

pp. 824–843

Sequential procurement auctions and their

effect on investment decisions

Gonzalo Cisternas∗

and

Nicol´

as Figueroa∗∗

We characterize the optimal mechanism and investment level in an environment where (i) two

projects of independent costs are purchased sequentially, (ii) the buyer can commit to a two-

period mechanism, and (iii) the winner of the first project can investin a cost-reducing technology

between auctions. We show that, in an attempt to induce more competition in the first period,

the optimal mechanism gives an advantage to the first-period winner in the second auction. As

a result of this advantage, the first-period winner invests more than the socially efficient level.

Optimal advantages, therefore, create two different channels for cost minimization in buyer-

supplier relationships.

1. Introduction

Managing relationships with suppliers is critical to the success of many firms. To achieve

low procurement costs, a buyer maywant to encourage competition among suppliers, but she may

also hope that suppliers make investments that lower their costs of production. Two extreme views

appear. The arm’s-length model—prevalent in the United States—promotes competition in every

period to strengthen a buyer’s bargaining power (Porter, 1985). The partnership model—adopted

in some Japanese industries—instead fosters long-term relationships by awarding advantages to

suppliers with records of good performance; in return, these suppliers invest in specific assets

that can reduce production costs.1

In this article, we ask how the desires to promote competition and, at the same time, to

encourage relationship-specific investments, may be best balanced to minimize a buyer’s cost of

procurement. Using the mechanism-design approach, we show that advantages to incumbents

can optimally arise in fully competitive environments characterized by the repeated interaction

∗Massachusetts Institute of Technology; gcistern@mit.edu.

∗∗Pontificia Universidad Cat´

olica de Chile; nicolasf@uc.cl.

We are especially grateful to Soledad Arellano, Leandro Arozamena, Alessandro Bonatti, Vinicius Carrasco, H´

ector

Chade, Bob Gibbons, Heikki Rantakari, and Mike Whinston for their valuable feedback on this article. We would also

like to thank the Editor, David Martimort, and an anonymous referee for very thoughtful comments. Figueroa was

partially supported by the Complex Engineering Systems Institute, Millennium Nucleus Information and Coordination

in Networks ICM/FIC RC130003, and by Fondecytgrant no. 1141124.

1See Dyer (1994) and Dyer, Cho, and Chu (1998) for evidencefrom the Japanese automobile industry.

824 C2015, The RAND Corporation.

SEQUENTIAL PROCUREMENT AUCTIONS AND THEIR EFFECT / 825

between a buyer and multiple sellers. Even more so, we show that these advantages can generate

strong incentives to invest in cost reduction. In dynamic settings, therefore, contracts that lie in

between the arm’s-length and partnership models can have a critical impact on the long-term cost

structure of suppliers.

In our model, a buyer must purchase two projects sequentially from a pool of potential

sellers. The sellers’ costs for performing both tasks are distributed independently across time and

across competitors, and they are private information to each firm. We assume that the first-period

winner can improve his cost distribution for the second competition by undertaking a costly

investment between auctions. This decision can be observable (and contractible) or not. In this

context, we characterize (i) the cost-minimizing mechanism chosen by a seller with commitment

power and (ii) the investment level carried out by the first-period winner. Because the return

from investing in a better technology depends on how the second-period mechanism treats the

first-period winner, the final degree of asymmetry between sellers is determined endogenously

by the optimal mechanism.

Our model fits many real-world examples of repeated buyer-supplier interactions in which

winning bidders have the possibility to invest to reduce their costs, or to improve the value

of the goods offered to the buyer. In the car industry, for example, there is vast evidence that

suppliers that win a contract in this industry get to better understand the manufacturers’ needs,

which allows for investments that better tailor products to the specific needs of the purchaser

(Richardson, 1993). A similar phenomenon takes place in spectrum auctions, where firms that

develop significant market positions investin their brand name and in their knowledge about their

customer base, thus developing a higher valuation for frequencies in future sales (Klemperer,

2004). In all these settings, the buyer faces an important choice. Should she promote competition

in every period to obtain lower prices? Alternatively, should she, instead, give an advantage to a

previous winner to foster investments that will eventually result in lower prices?

Although in practice all sellers have the potential to improve their technologies, there are

many instances in which significant investments take place only after becoming an established

provider. In the defense industry, for instance, technological capabilities developed through

learning-by-doing play a key role in shaping a seller’s cost structure. Winners of previous auc-

tions thus have a natural advantage over losers, as developing a final product provides them with

information that is unavailable to those sellers that stop at the design stage. A similar phenomenon

occurs in purchases that involve sellers making relationship-specific investments. Dyer (1994,

1996) documents that suppliers of Toyota and Chrysler undertook important relationship-specific

investments (manufacturer-specific software, human capital, proximity to plants, etc.) after be-

coming well-established providersto each firm.2It is often the case that these types of investments

are prohibitively costly for those sellers who are not currently serving the buyer. Alternatively,

sellers who have not been awarded previous contracts may lack the necessary information to

identify which types of investments effectively add value to the relationship.

As a benchmark, we first consider the ex post efficient mechanism: in each period,the project

is assigned to the lowest-cost supplier,and the efficient level of investment optimally balances the

cost of this decision with the benefit of having a better competitor when the efficient allocation

rule is in place. In this case, we show that the planner’s and the winner’s investment incentivesare

aligned. Consequently, the socially efficient level of investment can be implemented using two

second-price procurement auctions.

Wethen use the mechanism-design approach to characterize the cost-minimizing mechanism

under incentive constraints. When the buyer is able to commit to a two-period mechanism, we

show that the optimal mechanism gives an advantage to the first-period winner in the second

auction: it awards him the project, even in some cases in which his cost is larger than the cost of

other competitors. The reasoning is as follows. In the setting we study, the buyer cannot commit

2Investmentsin plant proximity also take place in the case of contracts for the distribution of school meals in Chile,

as winners build infrastructure in different regions of the country (Olivares et al., 2011).

C

The RAND Corporation 2015.