Last edited 07 Aug 2017

Auction theory

Contents

[edit] Introduction

Auction theory relates to the design of auctions and how this influences the bidding strategies of the parties taking part in the auction. Auctions take place in which different parties bid for the right to purchase goods or, in the construction industry, to win tender contracts for project work.

The four traditional types of auction are as follows:

[edit] First-price sealed-bid

Bidders hand bids to the auctioneer. Upon opening, the most suitable bid (highest or lowest) wins.

[edit] Second-price sealed-bid

Bidders hand bids to the auctioneer. Upon opening, the most suitable bid wins, paying equal to the bid which is judged second-most suitable.

[edit] Open ascending-bid (English auctions)

Bidders make increasingly high bids until no one is prepared to make a higher bid and one remains.

[edit] Open descending-bid (Dutch auctions)

An inflated price is set and is progressively lowered until the first bidder is prepared to buy.

Generally, the tendering process within the construction industry is the first of these – a first-price sealed-bid auction with multiple stages.

[edit] ‘Winner’s curse’

An element of auction theory, which can impact upon the construction industry, is the ‘winner’s curse’. This is when a bidding contractor wins the auction with a bid that is too low for them to make a satisfactory profit, if any at all.

However, while it is common for tendering processes to favour lowest bids, the construction industry does not operate on a strictly first-price sealed-bid basis, as other factors also come into play. An existing working relationship between employer and tenderer might give the latter an advantage over tenderers who are unfamiliar to the employer.

The employer might also be prepared to select a higher bid because there is an expectation of higher quality and reliability. It is just as important for the employer that the tenderer does not suffer the ‘winner’s curse’, since the project will be likely to be impacted negatively as a result of the tenderer trying to rush, cut costs or becoming insolvent.

[edit] Bid shopping

The construction industry has obtained something of a bad reputation in the past for corrupting the first-price sealed-bid auction design. This is known as ‘bid shopping’.

A sealed-bid auction is intended to proceed with tenderers only knowing their bid and not those of their rivals. However, what can happen is that the employer reveals the bids of tenderers to their rivals in an attempt to drive bids down lower. This turns the design of the auction into more of an English auction, and puts tenderers at a disadvantage compared to the employer. One way of avoiding this in construction is for tenderers to withhold their bid submission until right before the deadline, in the hope that this will prevent their bid becoming common knowledge to rivals.

[edit] Other forms of corruption

Two other forms of corruption can arise in construction when it comes to sealed-bid auctions.

[edit] Bid rotation

This occurs when a number of tenderers are involved in the auction process but only one of them places a bid, inevitably making them the winner. The tenderers collude together to rotate the title of ‘winner’ among themselves, meaning they are each assured of winning unrivalled a certain amount of work.

[edit] Phantom bidding

This is more common and involves all bar one of the tenderers submitting artificially high bids, while the one tenderer submits a lower bid which is still sufficiently high to ensure they make a profit. This is designed to give the impression of competition.

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