Precontractual investment and modes of procurement

Abstract

We study a repeated game in which a buyer must decide whether to procure goods whose design may turn out to be defective through auctions or negotiations. To reduce the likelihood of failure, the buyer must motivate the potential suppliers to make an investment before the contract is signed. As the noisy signal of the supplier's investment is non-verifiable, the buyer can induce the suppliers to invest only through relational contracts, that is informal agreements sustained by the parties' concern about the future. We find that auctions may not enable the buyer to implement a surplus-increasing relational contract even when the players are very patient. Therefore, negotiations may be adopted since they are more effective in stimulating the supplier's investment. We also show how the possibility of inducing the supplier's investment as well as the choice of the procurement mode affect the buyer's initial specification of the good. Moreover, we find that relational contracting may be valuable even when a design failure can be verified by a court. Finally, we highlight how our model is able to reconcile several real-world procurement practices.

Teaching an old dog a new trick: Reserve price and unverifiable quality in repeated procurement

“…33See, for instance, Manelli and Vincent (1995) and De Chiara (2020). Also, Bajari et al (2009) provide empirical evidence in the case of nonresident private sector building contracts in Northern California from 1995 to 2000.…”

“…77Our model borrows some of the main features of real‐world procurement procedures to explore novel welfare properties of a specific design dimension, namely the reserve price (or, equivalently, the budget). This approach is widely used in the procurement literature (see, for instance, Calzolari & Spagnolo, 2017; De Chiara, 2020; Herweg & Schwarz, 2018). An alternative approach would be to characterize the class of self‐enforcing relational contracts which maximize the buyer's utility among all possible buying mechanisms (see, for instance, Burguet, 2017; Burguet et al, 2012) and use it as a benchmark to evaluate the properties of some real‐word procurement procedures.…”