Managing project failure risk through contingent contracts in procurement auctions

Procurement auctions are sometimes plagued with a chosen supplier's failing to accomplish a project successfully. The risk of project failure is considerable, especially when the buyer has inadequate information about suppliers ex ante and the project can only be evaluated at the end. To manage such uncertainty, a model of competitive procurement and contracting for a project is presented in this paper. We study a setting in which suppliers differ in both the costs to fulfill the project and the types reflecting their success probabilities. To screen suppliers, the buyer invites suppliers to specify a two-dimensional bid composed of the proposed cost and a penalty payment if the delivered project fails to meet the requirements. We find that a quasi-linear scoring rule can effectively separate suppliers regarding their types. We then study the efficient and optimal design of the scoring rule. The efficient design internalizes the inferred information on suppliers' type and essentially ranks suppliers based on the expected total cost to the buyer. In the optimal design, the buyer may or may not under-reward suppliers' high success probability, depending on the balance between suppliers' success probabilities and the associated cost distributions. Interestingly, it is always optimal for the buyer to possibly award the project to suppliers with low success probability to promote the competition, even when the difference in suppliers' success probabilities is huge. We show that, compared to standard auctions, the procurement auctions with contingent contracts can significantly improve both social welfare and the buyer's payoff.