Bidding for Contests

Abstract

The procurement of product development and production services brings special strategic considerations to the buyer-seller relationship in industrial and institutional markets. Multiple sourcing, in particular dual sourcing, is a likely way of dealing with the increased risks faced by buyers. However, there is lack of dual sourcing models that analyze the selection and control process in an integrated fashion. This omission had led to apparently contradictory findings in agency and auction theory. The paper models the strategic issues for a cost containment contest between two suppliers. The suppliers are drawn from several vendors who participate in a bidding competition. The supplier with the lower final cost in the contest wins a larger share of the pooled profit fee. Propositions are derived for the optimal cost-plus contest, and comparisons are made with the common incentive contract for the integrated selection and control model. The larger the winner's share, the greater the effort. The buyer can make a credible commitment to the optimal winner's share. As the winner's share rises, however, the bid prices increase due to increased contract risk. This incentive-risk tradeoff determines (a) the optimal winner's share that minimizes expected procurement price, (b) the corresponding profit fee bid by suppliers, (c) the ensuing cost control effort, and (d) the final price for the procurement. Comparisons with the common incentive contract tell us when the cost-plus contest induces more effort, and when bidding for a contest results in a lower final procurement price.