In this guest post, Procurement Leaders invites CRA's Margarita Sapozhnikov to look at some of the misconceptions around auctions and why they don't always deliver the best price.
If we take the economist's view, we would have little doubt that an auction — properly designed and implemented for the circumstances — is the right way to handle large-scale transactions in the majority of industries. After all, such auctions achieve the "supply meets demand and sets the market price" result so often depicted as a fundamental principle of economics.
Even though modern technology has made on-line auctions — just one type of auction, it should be noted — available to many market participants, the overall auction approach is not as widely used as it could be, as both auctions to sell and procurement auctions are yet to gain the acceptance they deserve. But why?
Talking to decision-makers across industries we found a few misconceptions that may very well be the reason we do not see as many successfully implemented auctions as we would expect. Let's have a quick look at the most common one: "Auction is the on-line version of an RFP."
A Request for Proposal (RFP) is a widespread mechanism to procure goods and services in both public and private sectors. This is familiar territory: an RFP is issued by the buyer to solicit offers from suppliers. In academic terms, an RFP typically mirrors a one-shot sealed bid auction. As such, an RFP is one of numerous auction designs available, but in many situations it suffers from serious shortcomings.
Consider an RFP issued by a large chemical plant to procure its supply of natural gas for the next two years. The bidders are asked to guarantee the delivery at a fixed price. All bidders face market uncertainty, and also are uncertain of each other's valuations. As a result, they are cautious and their offers are priced much higher than what they estimate the value of the contract actually to be. This conservative bidding strategy mitigates against the "winner's curse" — the winning bidder knows only that they offered the lowest price and will wonder if they miscalculated the market value of the contract. Bidders in this type of procurement process face a great deal of uncertainty, which results in higher prices.
Now consider replacing the RFP approach with a descending-price clock auction: an auction with multiple rounds, where at each round bidders are asked the quantity they are willing to supply at the announced price for that round. We often advise to start a procurement auction with a price that all the bidders would find attractive and then gradually decrease it round by round. Even though bidders will not know the exact amount of each other's bids, they will see a measure of total bids in the aggregate. Because there is confirmation that other bidders value the contract similarly, this relieves some uncertainty and participants will be motivated to bid more aggressively (lower prices).
The winning bidder knows what they need to bid to stay competitive, and at the same time they are not at risk from the "winner's curse." Through this procurement process, bidders participate with more certainty and confidence, which results in lower prices.
When the procurement involves products that are close complements or substitutes, it is best to adopt a bidding mechanism that enables and encourages bidders to bid on the products simultaneously. The most extreme example of complements is a right and a left shoe. If an RFP is issued where each item or product is procured by itself, without a guaranteed way to win the pair or bundle, the prices offered by the suppliers will be much higher. Only some auction designs address complements and substitutes effectively, and achieve the buyer's objectives.
There are many ways to design an auction, and no one auction design is best in all situations. The most successful auctions combine art and science — combining economics, game theory, and market theory with the practical realities of actual marketplaces. When properly designed and implemented, procurement auctions can best achieve a wide range of objectives.
Margarita Sapozhnikov is an Associate Principal in CRA International's Auctions & Competitive Bidding consulting practice.