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January  2019, 15(1): 131-157. doi: 10.3934/jimo.2018036

Mechanism design in project procurement auctions with cost uncertainty and failure risk

1. 

College of Information Science and Engineering, Northeastern University, Shenyang 110819, China

2. 

Research Institute of Business Analytics & Supply Chain Management, College of Management, Shenzhen University, Shenzhen 518060, China

3. 

College of Information Science and Engineering, Northeastern University, State Key Laboratory of Synthetical Automation, for Process Industries (Northeastern University), Shenyang, Liaoning 110819, China

4. 

Department of Mathematics, The University of Hong Kong, Pokfulam Road, Hong Kong, China

5. 

Department of Industrial and Systems Engineering, National University of Singapore, 10 Kent Ridge Crescent, Singapore 119260, Singapore

6. 

College of Software, Northeastern University, Shenyang, Liaoning 110819, China

* Corresponding author: M. Huang

Received  April 2017 Revised  September 2017 Published  January 2019 Early access  April 2018

Fund Project: This work has been sponsored by Distinguished Young Scholars Award of NSFC Grant #71325002; Major International Joint Research Project of NSFC Grant #71620107003; Foundation for Innovative Research Groups of NSFC Grant #61621004; the 111 Project Grant #B16009; Fundamental Research Funds for State Key Laboratory of Synthetical Automation for Process Industries Grant #2013ZCX11; Research Funds of Shenzhen University Grant #2018059.

Project procurement has two important attributes: cost uncertainty and failure risk. Due to the incomplete feature of such attributes, a novel mechanism incorporating contingent payments and cost sharing contracts is proposed for the buyer. Constructing models of bid decisions for risk averse and risk neutral suppliers, respectively, closed-form solutions of optimal bid prices are derived. By investigating the properties of bid prices in a first-score sealed-bid reverse auction, we find that when the degree of risk aversion or the variance of unpredictable cost is sufficiently small, bid prices of risk averse suppliers could be lower than those of risk neutral suppliers. Yet risk averse suppliers always bid higher than risk neutral suppliers in a second-score sealed-bid reverse auction. An interesting result verified by numerical experiments is that the classical revenue equivalence theorem no longer holds for the proposed mechanism if suppliers involve risk averse behavior. In this case, the buyer's best choice is to adopt a first-score sealed-bid reverse auction. We also provide decision support for the buyer to achieve optimal expected profit.

Citation: Xiaohu Qian, Min Huang, Wai-Ki Ching, Loo Hay Lee, Xingwei Wang. Mechanism design in project procurement auctions with cost uncertainty and failure risk. Journal of Industrial and Management Optimization, 2019, 15 (1) : 131-157. doi: 10.3934/jimo.2018036
References:
[1]

J. Asker and E. Cantillon, Procurement when price and quality matter, Rand J Econ, 41 (2010), 1-34. 

[2]

P. BajariS. Houghton and S. Tadelis, Bidding for incomplete contracts: An empirical analysis of adaptation costs, Am Econ Rev, 104 (2014), 1288-1319. 

[3]

S. BenjaafarE. Elahi and K. L. Donohue, Outsourcing via service competition, Manage Sci, 53 (2007), 241-259.  doi: 10.1287/mnsc.1060.0612.

[4]

G. P. Cachon and P. Zhang, Procuring fast delivery: Sole sourcing with information asymmetry, Manage Sci, 52 (2006), 881-896.  doi: 10.1287/mnsc.1060.0510.

[5]

W. S. ChangB. Chen and T. C. Salmon, An investigation of the average bid mechanism for procurement auctions, Manage Sci, 61 (2015), 1237-1254. 

[6]

S. C. ChangM. M. Hsieh and C. W. Chen, Reverse auction-based job assignment among foundry fabs, Int J Prod Res, 45 (2007), 653-673. 

[7]

A. Chaturvedi and V. Martínez-de-Albéniz, Optimal procurement design in the presence of supply risk, M&SOM-Manuf Serv Oper Manag, 13 (2011), 227-243.  doi: 10.1287/msom.1100.0319.

[8]

Y. K. Che, Design competition through multidimensional auctions, Rand J Econ, 24 (1993), 668-680. 

[9]

F. Chen, Auctioning supply contracts, Manage Sci, 53 (2007), 1562-1576.  doi: 10.1287/mnsc.1070.0716.

[10]

J. ChenL. Xu and A. Whinston, Managing project failure risk through contingent contracts in procurement auctions, Decis Anal, 7 (2009), 23-39.  doi: 10.1287/deca.1090.0155.

[11]

R. R. ChenR. O. RoundyR. Q. Zhang and G. Janakiraman, Efficient auction mechanisms for supply chain procurement, Manage Sci, 51 (2005), 467-482.  doi: 10.1287/mnsc.1040.0329.

[12]

C. B. Cheng, Solving a sealed-bid reverse auction problem by multiple-criterion decision-making methods, Comput Math Appl, 56 (2008), 3261-3274.  doi: 10.1016/j.camwa.2008.09.011.

[13]

S. Dasgupta and D. F. Spulber, Managing procurement auctions, Inf Econ Policy, 4 (1990), 5-29.  doi: 10.1016/0167-6245(89)90030-9.

[14]

R. Deb and D. Mishra, Implementation with contingent contracts, Econometrica, 82 (2014), 2371-2393.  doi: 10.3982/ECTA11561.

[15]

I. DuenyasB. Hu and D. R. Beil, Simple auctions for supply contracts, Manage Sci, 59 (2013), 2332-2342.  doi: 10.1287/mnsc.1120.1705.

[16]

R. Engelbrecht-Wiggans and E. Katok, E-sourcing in procurement: Theory and behavior in reverse auctions with noncompetitive contracts, Manage Sci, 52 (2006), 581-596. 

[17]

C. Feldman, B. Wermund and C. Hlavaty, Fire official speculates on cause of Montrose blaze, Houston Chronicle, 2014, http://www.chron.com/news/houston-texas/houston/article/Fire-official-speculates-on-cause-of-Montrose-5347617.php.

[18]

R. G. Hansen, Auctions with endogenous quantity, Rand J Econ, 19 (1988), 44-58.  doi: 10.2307/2555396.

[19]

M. HuangX. QianS. C. Fang and X. Wang, Winner determination for risk aversion buyers in multi-attribute reverse auction, Omega-Int J Manage Sci, 59 (2016), 184-200.  doi: 10.1016/j.omega.2015.06.007.

[20]

X. HuangS. ChoiW. ChingT. Siu and M. Huang, On supply chain coordination for false failure returns: A quantity discount contract approach, Int J Prod Econ, 133 (2011), 634-644.  doi: 10.1016/j.ijpe.2011.04.031.

[21] V. Krishna, Auction Theory, Academic Press, Burlington, Massachusetts, 2009. 
[22]

J.-J. Laffont and J. Tirole, Auctioning incentive contracts, J Polit Econ, 95 (1987), 921-937.  doi: 10.1086/261496.

[23]

T. LiJ. Lu and L. Zhao, Auctions with selective entry and risk averse bidders: Theory and evidence, Rand J Econ, 46 (2015), 524-545.  doi: 10.1111/1756-2171.12096.

[24]

S. LiuQ. Hu and Y. Xu, Optimal inventory control with fixed ordering cost for selling by Internet auctions, J Ind Manag Optim, 8 (2012), 19-40. 

[25]

C. MaY. C. E. LeeC. K. Chan and Y. Wei, Auction and contracting mechanisms for channel coordination with consideration of participants' risk attitudes, J Ind Manag Optim, 13 (2017), 775-801. 

[26]

E. Maskin and J. Riley, Optimal auctions with risk averse buyers, Econometrica, 52 (1984), 1473-1518.  doi: 10.2307/1913516.

[27]

R. P. McAfee and J. McMillan, Bidding for contracts: A principal-agent analysis, Rand J Econ, 17 (1986), 326-338.  doi: 10.2307/2555714.

[28]

X. QianS.-C. FangM. HuangQ. An and X. Wang, Reverse auctions with regret-anticipated bidders, Ann Oper Res, (2017), 1-21.  doi: 10.1007/s10479-017-2475-6.

[29]

T. I. TuncaD. J. Wu and F. Zhong, An empirical analysis of price, quality, and incumbency in procurement auctions, M&SOM-Manuf Serv Oper Manag, 16 (2014), 346-364.  doi: 10.1287/msom.2014.0485.

[30]

F. WexG. SchryenS. Feuerriegel and D. Neumann, Emergency response in natural disaster management: Allocation and scheduling of rescue units, Eur J Oper Res, 235 (2014), 697-708.  doi: 10.1016/j.ejor.2013.10.029.

[31]

Z. B. YangG. AydinV. Babich and D. R. Beil, Supply disruptions, asymmetric information, and a backup production option, Manage Sci, 55 (2009), 192-209. 

[32]

Z. B. YangG. AydinV. Babich and D. R. Beil, Using a dual-sourcing option in the presence of asymmetric information about supplier reliability: Competition vs. diversification, Manage Sci, 14 (2012), 202-217. 

show all references

References:
[1]

J. Asker and E. Cantillon, Procurement when price and quality matter, Rand J Econ, 41 (2010), 1-34. 

[2]

P. BajariS. Houghton and S. Tadelis, Bidding for incomplete contracts: An empirical analysis of adaptation costs, Am Econ Rev, 104 (2014), 1288-1319. 

[3]

S. BenjaafarE. Elahi and K. L. Donohue, Outsourcing via service competition, Manage Sci, 53 (2007), 241-259.  doi: 10.1287/mnsc.1060.0612.

[4]

G. P. Cachon and P. Zhang, Procuring fast delivery: Sole sourcing with information asymmetry, Manage Sci, 52 (2006), 881-896.  doi: 10.1287/mnsc.1060.0510.

[5]

W. S. ChangB. Chen and T. C. Salmon, An investigation of the average bid mechanism for procurement auctions, Manage Sci, 61 (2015), 1237-1254. 

[6]

S. C. ChangM. M. Hsieh and C. W. Chen, Reverse auction-based job assignment among foundry fabs, Int J Prod Res, 45 (2007), 653-673. 

[7]

A. Chaturvedi and V. Martínez-de-Albéniz, Optimal procurement design in the presence of supply risk, M&SOM-Manuf Serv Oper Manag, 13 (2011), 227-243.  doi: 10.1287/msom.1100.0319.

[8]

Y. K. Che, Design competition through multidimensional auctions, Rand J Econ, 24 (1993), 668-680. 

[9]

F. Chen, Auctioning supply contracts, Manage Sci, 53 (2007), 1562-1576.  doi: 10.1287/mnsc.1070.0716.

[10]

J. ChenL. Xu and A. Whinston, Managing project failure risk through contingent contracts in procurement auctions, Decis Anal, 7 (2009), 23-39.  doi: 10.1287/deca.1090.0155.

[11]

R. R. ChenR. O. RoundyR. Q. Zhang and G. Janakiraman, Efficient auction mechanisms for supply chain procurement, Manage Sci, 51 (2005), 467-482.  doi: 10.1287/mnsc.1040.0329.

[12]

C. B. Cheng, Solving a sealed-bid reverse auction problem by multiple-criterion decision-making methods, Comput Math Appl, 56 (2008), 3261-3274.  doi: 10.1016/j.camwa.2008.09.011.

[13]

S. Dasgupta and D. F. Spulber, Managing procurement auctions, Inf Econ Policy, 4 (1990), 5-29.  doi: 10.1016/0167-6245(89)90030-9.

[14]

R. Deb and D. Mishra, Implementation with contingent contracts, Econometrica, 82 (2014), 2371-2393.  doi: 10.3982/ECTA11561.

[15]

I. DuenyasB. Hu and D. R. Beil, Simple auctions for supply contracts, Manage Sci, 59 (2013), 2332-2342.  doi: 10.1287/mnsc.1120.1705.

[16]

R. Engelbrecht-Wiggans and E. Katok, E-sourcing in procurement: Theory and behavior in reverse auctions with noncompetitive contracts, Manage Sci, 52 (2006), 581-596. 

[17]

C. Feldman, B. Wermund and C. Hlavaty, Fire official speculates on cause of Montrose blaze, Houston Chronicle, 2014, http://www.chron.com/news/houston-texas/houston/article/Fire-official-speculates-on-cause-of-Montrose-5347617.php.

[18]

R. G. Hansen, Auctions with endogenous quantity, Rand J Econ, 19 (1988), 44-58.  doi: 10.2307/2555396.

[19]

M. HuangX. QianS. C. Fang and X. Wang, Winner determination for risk aversion buyers in multi-attribute reverse auction, Omega-Int J Manage Sci, 59 (2016), 184-200.  doi: 10.1016/j.omega.2015.06.007.

[20]

X. HuangS. ChoiW. ChingT. Siu and M. Huang, On supply chain coordination for false failure returns: A quantity discount contract approach, Int J Prod Econ, 133 (2011), 634-644.  doi: 10.1016/j.ijpe.2011.04.031.

[21] V. Krishna, Auction Theory, Academic Press, Burlington, Massachusetts, 2009. 
[22]

J.-J. Laffont and J. Tirole, Auctioning incentive contracts, J Polit Econ, 95 (1987), 921-937.  doi: 10.1086/261496.

[23]

T. LiJ. Lu and L. Zhao, Auctions with selective entry and risk averse bidders: Theory and evidence, Rand J Econ, 46 (2015), 524-545.  doi: 10.1111/1756-2171.12096.

[24]

S. LiuQ. Hu and Y. Xu, Optimal inventory control with fixed ordering cost for selling by Internet auctions, J Ind Manag Optim, 8 (2012), 19-40. 

[25]

C. MaY. C. E. LeeC. K. Chan and Y. Wei, Auction and contracting mechanisms for channel coordination with consideration of participants' risk attitudes, J Ind Manag Optim, 13 (2017), 775-801. 

[26]

E. Maskin and J. Riley, Optimal auctions with risk averse buyers, Econometrica, 52 (1984), 1473-1518.  doi: 10.2307/1913516.

[27]

R. P. McAfee and J. McMillan, Bidding for contracts: A principal-agent analysis, Rand J Econ, 17 (1986), 326-338.  doi: 10.2307/2555714.

[28]

X. QianS.-C. FangM. HuangQ. An and X. Wang, Reverse auctions with regret-anticipated bidders, Ann Oper Res, (2017), 1-21.  doi: 10.1007/s10479-017-2475-6.

[29]

T. I. TuncaD. J. Wu and F. Zhong, An empirical analysis of price, quality, and incumbency in procurement auctions, M&SOM-Manuf Serv Oper Manag, 16 (2014), 346-364.  doi: 10.1287/msom.2014.0485.

[30]

F. WexG. SchryenS. Feuerriegel and D. Neumann, Emergency response in natural disaster management: Allocation and scheduling of rescue units, Eur J Oper Res, 235 (2014), 697-708.  doi: 10.1016/j.ejor.2013.10.029.

[31]

Z. B. YangG. AydinV. Babich and D. R. Beil, Supply disruptions, asymmetric information, and a backup production option, Manage Sci, 55 (2009), 192-209. 

[32]

Z. B. YangG. AydinV. Babich and D. R. Beil, Using a dual-sourcing option in the presence of asymmetric information about supplier reliability: Competition vs. diversification, Manage Sci, 14 (2012), 202-217. 

Figure 1.  Timing of events
Figure 2.  Comparison of ex ante expected payments of the buyer when facing risk averse suppliers in FSRA and SSRA
Figure 3.  Comparison of ex ante expected payments of the buyer when facing risk averse and risk neutral suppliers in FSRA
Figure 4.  Impact of parameters on β and ∆ for the buyer when facing risk averse suppliers in FSRA
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