E-sourcing in procurement: theory and behavior in reverse auctions with noncompetitive contracts

One of the goals of procurement is to establish a competitive price while affording the buyer some flexibility in selecting the suppliers to deal with. Reverse auctions do not have this flexibility, because it is the auction rules and not the buyer that determines the winner. In practice, however, hybrid mechanisms that remove some suppliers and a corresponding amount of demand from the auction market are quite common. We find that in theory such hybrid mechanisms increase competition and make buyers better off as long as suppliers are willing to accept noncompetitive contracts. It turns out that suppliers often do because under a wide variety of conditions, these contracts have a positive expected profit. Our theory relies on two behavioral assumptions: (1) bidders in a multiunit uniform-price reverse auction will follow the dominant strategy of bidding truthfully, and (2) the suppliers who have been removed from the market will accept noncompetitive contracts that have a positive expected profit. Our experiment demonstrates that bidders in the auction behave very close to following the dominant strategy regardless of whether this auction is a stand-alone or a part of a hybrid mechanism. We also find that suppliers accept noncompetitive contracts sufficiently often (although not always) to make the hybrid mechanism outperform the reverse auction in the laboratory as well as in theory.