Multistage Procurement Auctions

March, 2004

Mihkel Tombak1 Wei Wang2

Abstract
This study examines a procurement auction involving one buyer and many sellers with different costs. We determine the conditions under which a buyer would opt for a two-stage auction where in the first round some sellers are eliminated. The rationale for such a multistage auction is that the buyer can eliminate outliers in the cost distribution, thereby reducing the variance among bidders in the second round. We find the conditions under which setting a lower number of bidders to proceed to a second round is superior to establishing a reservation price. JEL: D44, D43

Rotman School of Management, University of Toronto at Mississauga and CIRANO, Email: mihkel.tombak@rotman.utoronto.ca 2 Queens School of Business, Queens University, Kingston, ON, Canada, K7L 3N6 Email: wwang@business.queensu.ca The authors would like to express their appreciation for the financial support of the Centre for Automotive Materials and Manufacturing (CAMM), the Natural Sciences and Engineering Research Council of Canada (NSERC) and the University of Toronto. We are grateful for helpful suggestions and comments from Arieh Gavious, Glen Takahara, and seminar participants at Queens University.

1. Introduction
Due to the advent of online auctions, there has been an enormous change in the use of auctions and their design. The decisions faced by buyers and sellers regarding the use of auctions are far more complex than ever before. Online auctions have become popular in recent years because of the: reduced transaction costs for both buyers and sellers; easier description of complex products; ability to conduct complex auctions; accessibility to more participants, both bidders and sellers; and easier collection of data about auctions (Pinker et al, 2001a, 2001b, and Lucking-Reiley, 2000). In this study, we focus on when more complex procurement auction mechanisms should be used; in particular, we examine when multistage auctions should be utilized.

The business-to-business auction market is substantial; it is forecasted that the total annual volume of transactions realized through online business-to-business (B2B) auctions in the U.S. will reach $746 billion by 2004 (Kafka, Tempkin, Wegner, 2000). Procurement auctions are an important segment of this B2B auction market. Such auctions can be split into multiple stages. For example, Covisint (http://www.covisint.com) 3, which was founded in 2000 by, Ford Motor Co., General Motors Corp., and DaimlerChrysler AG, handles 100 million supply-chain procurement transactions per month between 2,000 suppliers and the automakers. Covisint hosts an enhanced version of Ford's Supplier Network, a private extranet used to manage more than $90 billion in procurement annually. Covisint allows buyers some flexibility in designing the auction mechanism. One of the options to buyers in Covisint is to conduct either a one-stage or two-stage auction. In the standard one-stage auction, bidders submit their bids once and the lowest price bid wins the contract. In the two-stage auction, the number of possible suppliers is narrowed in the first stage of the auction and the supply contract is awarded to the winner of the second stage.

We study such multistage procurement auctions and contrast those with single-stage auctions to see under what market conditions such a multistage procedure would be advantageous to the buyer. We find that buyers can obtain better prices by using multistage procurement auctions when there are suppliers who are outliers in terms of
3

Another example is Sorcity.com, a reverse auction service website for industrial products and services.

their costs that are eliminated in the first round. Under certain conditions, the multistage mechanism we propose outperforms the setting of reservation prices in single-stage auctions.

One of the auction mechanisms in Covisint is similar to the Anglo-Dutch auction described in Klemperer (2000). In that Anglo-Dutch auction for four licences, the price rises continuously until the top five bidders remain. The five survivors make sealed-bids, which are required to be no lower than the current price level, the top four bidders win a license and pay the fourth highest bid. We find that in two-stage auctions like the one described above, by eliminating weak bidders in the first stage and thereby reducing the asymmetries among bidders, the auctioneer might receive a price that is lower than in a purely ascending auction. Furthermore, the information burden for the auction designer is less for a multistage auction than for establishing reservation prices.

For a procurement auction, a reduction in variance of suppliers costs can be achieved through the elimination of bidders in the first round. In this case, a two-stage procedure can be advantageous for the buyer when there are many bidders and a few outliers in the cost distribution. In her analysis of procurement auctions with endogenous quantities, Chiesa (2003) has results that accord with ours. She shows that a concentrated market with few large and fairly symmetric suppliers may be more competitive than one with many players of different size. The average bidding price is an increasing function of the degree of asymmetry of the largest market shares. Chiesas study and our analysis illustrate a more general point: that competition arises through the symmetry between competitors as well as through the number of competitors. We find that the buyer can affect the degree of asymmetry and the number of suppliers through the use of multistage auctions.

Most of the auction literature focuses on the common one seller, many buyer auctions. For excellent and comprehensive surveys of this literature, see Klemperer (1999), McAfee and McMillan (1987), and Milgrom (1989). Procurement auctions have some special features. In Hansen (1988) and Milgrom (1989), first-price procurement auctions are considered. It is assumed that each bidders cost is private and bidders can produce as many units as are demanded at a certain cost per unit. Quantity produced is a function of the bid price and is a monotonic decreasing function of price. Hansen (1988)

shows that the average price is lower and the expected quantity is greater in the firstprice sealed-bid auction than in the second-price sealed bid, or English auctions. Hansen (1988), however, only considers the case of two bidders and does not provide a closed-form solution for the equilibrium bid for each bidder. In this study, we are able to provide an explicit solution for the equilibrium bidding function for any number of bidders but for a given quantity.4

Other studies which examine some of the special features of procurement auctions include Budde and Gox (1999), Che (1993), and Branco (1997). Budde and Gox solved the bidding strategies in procurement auctions when capacity costs and additional capacity planning are taken into consideration. Che (1993) and Branco (1997) consider a model of a two-dimensional auction with quality and price. They show that mechanisms based on a single-stage auction are not optimal and thus introduces a twostage auction mechanism. In this study, we show that there may be reasons to have a multistage auction in the absence of quality concerns.

This paper is organized as follows. The following section develops and analyses a single-stage procurement first-price sealed bid (FPSB) auction model based on the independent-private-value benchmark. Following that, two-stage procurement auction models are developed whereby some bidders are eliminated in the first stage. The first multistage auction model has an English auction in the first stage and FPSB in the second stage. Subsequently, we develop a multistage model with FPSB in both stages in order to assess the impact of information revelation to the sellers. Next we examine procurement auctions with reservation prices and provide numerical examples. We conclude with a discussion of our results comparing the bidding of multistage models with that of single-stage models both with and without reservation prices.

Wellman et. al. (1999) and Milgrom (2000) analyse a mechanism for endogenous quantity for procurement auctions with capacity constraints.

2. Procurement Auction Models

In this section, we initially develop and analyze single-stage models of procurement auctions. Our focus is on FPSB auctions. Subsequently, two-stage auction models will be developed and examined. We consider situations when English auction is adopted in the first stage, and then when FPSB auction is adopted in the first stage while a FPSB auction is also adopted in the second stage. We next study procurement auctions with a reservation price, including both one-stage auctions and two-stage auctions when a reservation price is set by the buyer.

Throughout our analysis, we shall assume:

1.

The seller is marginal cost of production Ci is privately known by seller i. Costs are independently and continuously distributed in [0, M,] and are drawn from a common distribution F(Ci). F(Ci) is twice differentiable and has density function f(C).

2. The bidding function B (C i ) : [0, M ] R + is a monotonic increasing continuous function of Ci; bids made are statistically independent. 3. The selling firms are rational, risk neutral, and try to maximize the expected value of their profits.

Furthermore, we suppose there is a fixed and exogenous number of bidders in the market and each of them has a different production scale; thus they are able to provide similar products at different prices. Our setting is one of independent private values. Let n be the number of bidders who enter the auction and the costs of n random bidders be arranged such that C1 < C 2 < ... < C n , the order statistics of the costs. Following Reny (1999) and Athey (2001), a pure strategy Nash equilibrium exists under the singlecrossing condition. This is described as whenever each opponent uses a nondecreasing strategy, a players best response strategy is also non-decreasing. This condition is satisfied in independent private value setting. The result can be applied to show the existence of equilibrium in our symmetric independent private value auctions.

In appendix A we analyse a one-shot first-price sealed-bid procurement auction. Sellers compete through price-bidding for the right to sell a pre-specified quantity of product.

The seller offering the lowest bid will win the auction and supplies the product at the winning bid price. Each bidders payoff function is common knowledge among all the bidders but each bidders cost is privately known. From the revenue-equivalence theorem and optimal auction design, by Vickrey (1961), Riley and Samuelson (1981) and Myerson (1981) we predict that the expected payoff to the buyer is independent of the bidding rules, as long as equilibrium has the properties that the bidder with the best valuation wins. Therefore, the expected payoff to the buyer from all types of one-stage procurement auctions tends to be the same. We solve the equilibrium bidding strategy in the FPSB auction in Appendix A.

2.1 A two-stage procurement auction

In our subsequent analysis, we consider a two-stage auction with different number of players in each round of bidding. We assume there are n1 players entering this auction and submitting their bids in the first stage. After n1 - n 2 (where n1 > n 2 ), players are eliminated by the auctioneer before the second stage; only n 2 number of bidders enters the second stage. At the second stage of this auction, the bidder with the lowest bid wins and will supply its products to the buyer at the bid price. In our study, price is considered the only factor that determines which players proceed to the second stage and which player wins the auction.

For notation, we denote set B f = ( B1f , B2f , B3f ,...Bnf ) as the set of strategies of n1 bidders in
1

the first stage, and set B s = ( B1s ( B1f , B 2f , B3f ...B nf ), B 2s ( B1f , B 2f , B3f ,... B nf ),... B ns ( B1f , B 2f , B3f ,... B nf ))
1 1 2 1

as the set of strategies of n 2 bidders in the second stage. We define the minimum bid
f from the first round as Bmin = Min( B f ) .

As in the one-stage static game with incomplete information, there is a unique pure strategy Nash equilibrium, which is the set of equilibrium strategies (A3) of each bidder and the bidder with the lowest cost of production is declared the winner. Standard game theory shows that if a stage game of a finitely repeated game has a unique Nash equilibrium, then any finitely repeated game has a unique subgame-perfect outcome,

i.e., the Nash equilibrium is played in every stage. In our model that implies that if there is the same number of players in each stage of a finitely repeated auction, the same equilibrium bidding strategies are adopted in each stage of the game and the bidder with the lowest cost structure is declared the winner. Therefore, there is no difference to the buyers expected payoff of conducting a one-stage auction or a two-stage auction with the same number of bidders in each stage. However, with a different number of bidders in each stage, the identical pure strategy adopted in the one-stage auction may not be optimal for the two-stage auction.

The two-stage auction mechanism described above is used in Covisint. The following illustrates in detail how a buyer conducts an auction on Covisint by using a specific auction mechanism. Suppose a buyer has sent out a request to several suppliers to receive quotes for 10,000 pistons5. After having received and evaluated all quote responses, the buyer now is able to narrow the bid list down to m qualified bidders. All the m bidders meet the buyers quality, delivery, capacity, and technical capability requirements. In order to make the final decision, this buyer would like to create an online auction using Covisint where it will choose and invite n1 bidders to participate. First, this buyer logs into Covisint.com as a registered user and creates its auction using the single-step auction creation form. In the next step, it selects the category for its auction and the type of auction it wishes to conduct.6 After naming the auction, adding in a description and selecting the start and stop time, the currency type, opening price, and bid decrement are chosen. The invited bidders can log in into Covisint as registered users to submit their bids. Once the bids have been submitted, a golden gavel appears on the screen to show if the bid is in a leading position, or alternatively, all the bids can be observed by each bidder if an English-type auction is adopted. After observing all the first round bids submitted, this buyer can choose three bidders to enter the second round (the number of bidders to proceed to the second round is common knowledge before the auction starts). These chosen bidders are notified electronically via email of all secondround auction rules.

On Covisint the auto parts traded include: nuts, bolts, screws, steering wheels (molding, casting, sewing, assembly), airbags (molding, stamping, assembly), seat belts (stamping, molding, assembly), safety electronics, front axle (beam, cast iron, powerlite aluminium), rear axle (SG iron, cast iron, powerlite aluminium), driveshaft transmission components (forged) (shafts, gears, hubs, races), structural stampings, flywheels (cast), engine bearings, valves, springs, pistons etc. 6 It can be an English auction or a FPSB auction.

From the above illustration of Covisints auction mechanism, the auction is made up of two stages. At the first stage, the buyer invites n1 sellers to the auction (which can be either an FPSB auction or English-type auction), the bidders submit their sealed-bids or open-bids, and the buyer selects the most satisfactory n 2 companies. In the second stage, an FPSB auction stage is adopted. In the autoparts industry, given a fixed quantity supplied, different producers may have heterogeneous costs of production according to their economies of scale. Some weak suppliers may have incentives to enter the first stage of the auction hoping they may have a chance to enter the second stage and win the auction. Bidders with low cost structures may be able to bid with high profit margin by supposing there are many bidders with high cost structure. Then the auction mechanism adopted at Covisint can increase the competition among the bidders with low cost structures in the final stage by eliminating those weak bidders in the first stage, thus reducing the variance of the distribution of costs.

Next we consider two cases for the two-stage auction. First, in section 2.1.1, we study a two-stage auction with information revelation where an English auction is adopted in the first stage and the FPSB auction is adopted in the second stage. The reservation price set by the buyer is equal to the minimum bid submitted in the first stage. In this case, the value of bids can be observed by the buyer and all other bidders who are invited to enter the second round. Then n 2 bids in the second round must not exceed the minimum bid from the first round. So a sellers bid submitted in the first round may act as a ceiling to their bid in the second round. The bidder submitting the lowest bid in the second round wins the auction. This particular auction mechanism is used by Covisint.

In section 2.1.2, we then study a multistage procurement auction without information revelation to the sellers. FPSB auctions are adopted in both stages and the bids submitted in the first stage can be observed by the buyer. The buyer does not reveal any information about these bids to other suppliers who are invited to enter the second stage. In the second stage, n 2 bidders submit their bids again. Each bidder who enters the second stage is required to submit a bid that is lower or equal to the bid submitted in

the first round. The bidder submitting the lowest bid wins the auction and supplies its product to the buyer at the bid price.

2.1.1 English auction in the first stage

The bidding rule for this particular two-stage auction is defined as follows. First, each bidder among n1 bidders submits their bids Bi f , for i=1,2, n1 , in the first round. Then the buyer and all other bidders are able to observe all the bids submitted and bidders are able to subsequently revise their bids. The buyer narrows the number of bidders in the second stage down to n 2 . This number of bidders proceeding to the second stage is predetermined and announced by the buyer before the start of the first-round bidding. These n 2 bidders bids are the lowest among n1 bidders. The bidding rule for the second stage requires that each bidder entering the second stage submits a bid that is either below or equal to the minimum from the first stage.

In the first stage, the objective of each bidder is to submit a bid that will allow the seller entry to the second round of the auction. In the absence of the bid ceiling constraint in the second-stage auction, by any bidding rule each bidder would simply submit a bid of zero in order to maximize the probability of entering the second stage. However, since the maximum bid each bidder can submit in second stage is the minimum bid submitted in the first round, bidders need not only to maximize the probability of entering the second round but also to consider how their bids in the first round may affect the bid ceiling in the second round. Therefore, the optimal strategy for bidder i in the first round of auction is to maximize the probability of entering the second stage while bidding
f Bi f B min Bis C i .

When an English auction is adopted in the first stage, all n1 sellers are able to observe bids from other bidders. Any bidder i realizes that as long as the bid submitted stays in the lowest n 2 bids, that bidder is able to advance to the second round. Each bidder is able to keep revising their bids in order to stay in the lowest n 2 while bidding higher than their costs. Therefore, most of the advancing bids observed should be close to the value

of the n 2 +1st sellers cost. 7 In the second stage, the distribution of costs among bidders
f becomes G(Ci) where C i [0, B min ] . Let Cn2+1 denote the value of cost of the bidder next to

f n 2 bidders chosen to advance to the second round. Since Bmin can be trivially close to

Cn2+1, in order to simplify the problem we assume the distribution of costs in the second round becomes G(Ci) where C i [0, C n
2 +1

8 ] .

If an FPSB auction is now adopted, following equation (A3) and by assuming uniform distribution, the bidding strategy for bidder i in the second round becomes:

B * (C i ) = C i +

1 (C n2 +1 C i ) . n2

(1)

Following the revenue equivalence theorem (Vickery,1961, Myerson,1981, among others), the buyers expected payment is completely determined by the probability of winning. The winning seller should have the lowest cost structure and the seller with the highest cost in the cost distribution would expect to sell no products to the buyer. Therefore, by the revenue equivalence theorem, the expected payoff to the buyer in a one-stage FPSB auction is the same as the expected payoff in a two-stage auction.9

The revenue equivalence theorem, however, deals with ex ante expectations of the buyer given what is known to the buyer and other sellers about the cost distributions. That is, the buyer expects that the sellers will have expectations of the costs of their bidding rivals and bid accordingly. In the course of this multi-stage auction, however, information is revealed and the ex post prices may differ. Comparing the equilibrium bids (A4) and (1) we obtain,

This analysis is similar to that of multiple unit auction in Vickery (1961). Bidders with the highest n 2 values will submit a bid that is equal to the n 2 +1st bidders value and the result is Pareto optimal. 8 Roth and Ockenfels (2003) empirically show that in many internet auctions with fixed closing times bidders have engaged in sniping, or waiting until the final minute of the auction to submit a bid. One way to remedy this is to allow the extension of the closing time of the auction, which many online auction mechanisms allow. Therefore, each bidder is always able to continuously repeat bidding, higher than cost, until the bidder is able to stay among the n 2 bidders who enter the second stage. 9 The distribution of the ith smallest draw in a sample of n drawn from a uniform(0,1) distribution of random variables has a Beta(i,n-i+1) distribution with a mean of i/(n+1). The expected winning bids then have the same value in both one-stage and two-stage auctions. The expected bid from the lowest bidder is equal to the second lowest bidders expected cost for both auctions.

10

Proposition 1: Multistage auctions yield lower prices to the buyer than one-stage auctions if and only if:

( M C1 ) n1 . < n 2 (C n2 +1 C1 )

(5)

Proof: In order to induce each bidder to bid lower in a multistage procurement auction, the equilibrium bid in (1) has to be lower than that in (A4). That is,
Ci + 1 1 (Cn 2 +1 Ci ) < Ci + ( M Ci ) . The buyer prefers a multistage auction only if this n2 n1

condition holds for the lowest bidder, which gives the condition in the Proposition.

Q.E.D.

Condition (2) in Proposition 1 shows the tradeoff between reducing the number of bidders from n1 to n 2 (which would tend to increase the bid prices) and reducing the variance among bidders (i.e., reducing the upper bound of the distribution from M to Cn
+1
2

, which would tend to reduce the bid prices).

The difference of the ex post payoff to the buyer of a single-stage auction and a multistage auction becomes small as the cost of the lowest bidder lies significantly above the lower bound of cost distribution. That is, the advantage the buyer expects from a multistage auction declines as the cost of bidder 1 deviates significantly from 0 in our model. The extra payoff a multistage auction brings to the buyer is the difference of (6) and (3) for bidder 1, which is (Cn 2 +1 C1 ) / n2 (M C1 ) / n1 = Cn 2 +1 / n2 M / n1 + C1 (1/ n1 1/ n2 ) . Since n1 > n 2 , the extra payoff of a multi-stage auction over a single-stage auction is a decreasing function of C1 given M and Cn
2

+1

. Furthermore, the advantage of a

multistage auction is a decreasing function of M and n2 while it is an increasing function of n1.

11

The above proposition shows that even when the expected payoff to the buyer is the same in two different types of auctions, the choice of auction design is not irrelevant to the buyer ex post10. The following example shows that for different cost distribution realizations how the ex post payoff to the buyer can differ.

In this numerical example, we suppose M=1, n1 =4, n 2 =3 and a cost realization of (i)

C1 =0.10, C2 =0.20, C 3 =0.30, C4 =0.40, (ii) C1 =0.10, C2 =0.20, C 3 =0.40, C4 =0.75, (iii) C1 =0.10, C2 =0.30, C 3 =0.80, C4 =0.90 of three different cases. In all cases, bidder 1
has the same cost but the other three bidders have different costs structure. The expected winning bid, submitted by bidder 1, is calculated and equal to 0.40 in both onestage auction and two-stage auction. The ex post winning bid is equal to 0.32 in an onestage auction but equal to 0.20, 0.32, 0.37 in a two-stage auction for three cases respectively.

In the above example, four bidders enter the auction. Costs of bidders are uniformly distributed in (0,1). If adopting a single-stage auction, the buyer receives the same actual winning bids for all three cases. In a two-stage auction, however, bidder 1s winning bids differ significantly in the three cases. In case 1, bidders 1, 2 and 3 continue bidding until bidder 4 drops out. Then bidder 1 will realize that the upper bound for the cost distribution has decreased to 0.4 from 1. That is, the asymmetry of bidders costs has decreased in the second stage. This increased symmetry then induces bidder 1 to bid lower than if the auction is only run once. In case 2, the reduction in the number of bidders compensates for the reduction in the upper bound of cost distribution. In this case, bidder 1 submits the same bid as in the one-stage auction. Case 3 yields a higher winning bid in the two-stage auction than in the one-stage auction. In this case, after bidder 4 drops out the asymmetry of bidders costs has not been reduced enough for bidder 1 to bid low enough to increase the probability of winning. From an ex ante point of view, all three cases give the same expected payoff to the buyer, but the buyer should adopt a two-stage auction for case 1 and a one-stage auction for case 3.

Proposition 1 also illustrates a more general point: that competition between bidders depends not only on the number of bidders but also on the symmetry between bidders.
10

Here we adopt the term ex post to describe the realization of the winning bids.

12

An added bidder that has high costs does not add much to the competitiveness of the bidding. If the extent of the reduction in the number of bidders is smaller than that of the reduction in variance of the distribution of costs, a multistage auction is preferred by the buyer to the one-stage auction.

2.1.2 FPSB auction in first stage

The auction we examine in this section is composed of two FPSB auctions. As in the above multistage auction, n1 bidders enter the auction but now they submit their sealedbids to the buyer. The buyer does not disclose any information about the bids received but simply selects the lowest n 2 bidders to enter the second stage. The buyer asks these n 2 bidders to submit a bid that is no greater than the bid submitted in the first round. Then n 2 bidders submit their sealed-bid to the buyer. Finally, the bidder that submits the lowest bid wins the auction and supplies the product at the bidding price.

For this kind of two-stage repeated auction game, only the bidders with low cost structures are left after the first stage. Thus, the cost distribution for bidders becomes different in the second stage. With fewer bidders and a different cost distribution, the bidders equilibrium bidding strategy will be different from that adopted at the one-stage static game. The Nash equilibrium bidding strategy adopted in the one stage auction is not necessarily optimal for such a two-stage auction.

Since there is no update to each sellers information after the first stage, the decision problem is formulated in stage 1. The objective for each bidder in the first stage is to maximize the expected profit by adopting bidding strategies of Bi f and Bis , which satisfy condition Bi f Bis C i . That is, MAX B f , B S E ( profit ) . By using a conditioning argument we
i i

can rewrite the objective function as

MAX B f , B S ( Bis C i ) P ( win | advancing ) P ( advancing )

i i

(3)

where P(.) denotes a probability function.

13

Therefore, bidder is problem becomes

n 2 1 n1 1 1 f f n11 k MAX B f , B s ( Bis C i )(1 G ( B 1s ( Bis ))) n 21 { F ( B 1 f ( Bi f )) k } (1 F ( B ( Bi ))) i i k k =0 f s s.t Bi Bi C i

(4) where G(.) denotes the expected distribution function of the costs of n 2 bidders in the second stage. G(.) is different from F(.) since the upper bounds of distribution in the second stage are expected to decrease, and thus the distribution is altered. The solution to the above problem leads to

Lemma 1: Equilibrium bids in a two-stage FPSB-FPSB auction are given by:

n2 1 n1 1 n2 1 n1 1 k F ( y ) k }dy ( 1 G ( y )) { k (1 F ( y )) k =0 = Ci 0 n2 1 n1 1 n1 1 k (1 G (C i )) n2 1 { F (C i ) k } k (1 F (C i )) k =0 Ci

Bi f

FPSB FPSB*

= Bis

FPSB FPSB *

(5)

(1 G (C i )) n2 1 {
k =0

n2 1

K n1 1 n1 11k F (C i ) k k (1 F (C i ))

Proof: See Appendix C.

If we let n 2 = n1 , that is, all the bidders that bid in the first round are allowed to enter the second round, then the equilibrium bid simply becomes that of equation (2). Thus, if a two-stage FPSB auction is run with the same number of bidders, the equilibrium bid is the same as that in the one-stage auction. Note also that the bids in the first stage and second stage are the same. The bidder has no new information between rounds and since any increase in its first round bid will reduce the sellers chances of getting into the second round, there is no incentive to bid any differently. We will make numerical comparisons of the result in (5) with that of the English-FPSB multistage counterpart (1) in section 2.2.3.

14

2.2

Procurement auctions with reservation prices

Milgrom and Weber (1982) and Krishna (2002) show that a small reservation price can lead to an increase in revenue in a selling auction. A profit maximizing buyer should then set a reservation price that is below its own cost of production (assuming the buyer is capable of production). This is analogous to the selling auction where the seller has their own valuation of the object. There is then a positive probability that setting a reservation price may result in no bids even when at least one bidder would have been able to produce at a cost that is lower than buyers own cost of production.11 For an efficient auction, the selling opportunity should end up with the seller that produces the object at the lowest cost. A reservation price may be able to increase the payoff of the buyer but also may reduce the efficiency of the auction.

By the exclusion principle, it is optimal for the buyer to keep some bidders out of the auction even though some of their costs may actually be below the buyers own cost of production. As n 2 < n1 , the multistage auction is a method of applying the exclusion principle. We will show that setting the number of n 2 is equivalent to setting a reservation price and it may give a better payoff to the buyer ex post. Setting n 2 < n1 does not imply any risk such that the buyer receives no bid at all and thus achieves a more efficient auction. The other benefit of setting n 2 < n1 is that the buyer is able to shrink the distribution interval and reduce the asymmetries between bidders (as does the setting of a reservation price).

In a general setting, it has been assumed that the reservation price is publicly announced prior to the auction. It prohibits the sellers who have costs above the reservation price from entering the auction. However, in our setting, the buyer only announces the reservation price after observing characteristics of the bidders that enter the auction. It makes the buyer set a reservation price that not only makes it achieve a better payoff but also makes the auction achieve efficiency.

We first consider a FPSB auction with a reservation price set by the buyer. Then we analyse a two-stage procurement auction where an English auction is adopted in the first

11

This would happen, for example, when U < C1 < C 0 .

15

stage. We solve the equilibrium bidding strategies for each bidder both when a reservation price is announced in the first stage and when a reservation price is announced in the second stage.12

2.2.1

Single-stage FPSB auction

A buyer invites to bid all the current producers that are able to offer products with a satisfying quality level. The buyer observes that n bidders have entered the auction and the cost distribution is known (F(Ci) within [0,M]). The buyer then decides to announce a reservation price U.13 The bidder who submits the lowest bid wins the auction and provides its products to the buyer at the price bid.

Any bidder i that submits a bid must have costs below the reservation price U. Because of the uncertainty in the number of bidders whose costs are below U, each bidder that submits a bid will calculate the probability of having n=1, 2, , n-1 other bidders bidding and thus adopt a mixed strategy.

Let Z denote the number of other bidders who submit a bid among n bidders, and k = 0, 1 n-1, Z = {k | C k U ) , P[ Z = k ] , then for any bidder i, the probability that k other bidders will bid in the auction is

n 1 k n 1 k P[Z = k ] = , for k = 0,1, Kn1 1. F (U ) (1 F (U )) k

The objective for bidder i is to maximize expected profit, i.e.,

n 1 MAX B ( Bi C i ) P ( winning | Z = k ) P ( Z = k ) i k =0
As with equation (1), now we can rewrite bidder is optimization problem as

n 1 1 k n 1 k n 1 k MAX Bi ( Bi Ci ) ( 1 F ( B ( B ))) F ( U ) ( 1 F ( U )) i k 0 k =

(6)

12

The analysis of a two-stage FPSB-FPSB auction with a reservation price set in the first stage is rather complex but is available upon request from the authors. 13 This auction mechanism of setting a reservation price after observing the bidders is also supported by Vincent (1995). In such an auction mechanism, the buyer is able to induce more participants to enter the auction.

16

Lemma 2: Equilibrium bids in a single-stage FPSB auction with reservation price are given by:
B (C i ) = C i
*R

Ci

(1 F (U ) F ( y )) n 1 dy
n 1

(1 F (U ) F (C i ))

K (1 F (U ) F (C i )) n 1

(7)

Proof: See Appendix D.

After applying a uniform distribution for costs among bidders, we have F(Ci ) =
and F(U) =

1 Ci , f (Ci ) = , U U

U . Then the equilibrium bidding strategy in (7) becomes the same as that in M

(A4). Consequently, under the assumption of a uniform cost distribution, a buyer setting a reservation price does not make any difference to the equilibrium bidding strategies for bidders whose costs are below the reservation price.

2.2.2 A two-stage auction with an English auction in the first stage

2.2.2.1 When a reservation price is announced in the first stage The buyer invites all the available bidders to enter the auction. The buyer observes the number of bidders that enter ( n1 ). The buyer announces a reservation price U, and an English auction is adopted in the first stage. It is also announced that only the lowest n 2 bidders will be allowed to enter the second stage. Also, the buyer requires that each bidder submit a bid in the second round that is less than or equal to the bid they submitted in the first round. In the second stage, a FPSB auction is implemented. If the reservation price is set too low and U C 1, then there will be zero bids. When U > C 1 , since only the lowest n 2 bidders are allowed to proceed to the second stage, as long as U > Cn 2+1 the buyer should expect the same bidding behaviour from the different bidders in the first stage. That is, all the first round bids would be very close to C n2 +1 . The equilibrium bidding strategy in the second stage then is the same as that in (4). Thus, if

17

the reservation price set by the buyer is higher than the n 2 + 1st bidders cost reservation price, that reservation price makes no difference to the winning bid in a two-stage procurement auction. If, however, C1 < U Cn
2

+1

, only k bidders will enter the second

stage and all the bids received by the buyer should be close to U. In this case, the upper bound of cost distribution in the second stage becomes U. Following the same analysis as in 2.1.1, we are able to solve the equilibrium bidding strategy for bidder i conditional on k bidders proceeding to second stage. When cost distribution is assumed to be uniform, it is
B * (Ci ) = Ci + 1 (U Ci ) . k

Let P[ Z = k ] denote the probability that k bidders will bid in the first round of the auction. We have
n1 n1 k k P ( Z = k ) = P (C1 , C 2 ,...C k < U & C k +1 ,..., C n1 > U ) = k F (U ) (1 F (U ))

for C1 < U Cn +1 and k=1,2, n 2 .

2

We also have the probability of U C1 equal to (1 F (U )) n , which is denoted

1

as P[Z = 0] . Thus, the probability of U > C n 2+1 is equal to 1 P[ Z = k ] .

k =0

n2

After the announcement of the reservation price U in the first stage, the winning bid the buyer expects to receive, that is submitted by bidder 1 is equal to
n2 n2 n1 n1 1 1 n1 k n1 k k k + (Cn2 +1 C1 )){1 F ( U ) ( 1 F ( U )) } (C1 + (U C1 )) k k F (U ) (1 F (U )) } n2 k k =0 k =1

E{B1 } = E{(C1 +
R

(8)

In the special case when n 2 = n1 , then all the first round bids should lie very close to but below the reservation price U. In the second stage, all bidders are able to observe the number of bidders that enter the second stage. The new distribution G(.) has an upper bound of U. In the second stage, it becomes a one-stage FPSB auction with a reservation price. Lemma 2 shows the closed form solution of symmetric equilibrium bidding strategies with a reservation price. With uniform cost distributions, as shown

18

before, the equilibrium bidding strategies with reservation price are the same as those without a reservation price in a one-stage auction. Therefore, with n 2 = n1 , the expected winning bid is equal to that of a one-stage auction with a reservation price.

Setting the number of bidders that are allowed to enter the second stage is another way of setting a reservation price. It, however, eliminates the probability that the buyer may get zero bids and thus achieves a more efficient auction. From (4) and Table 1, we are able to see that, under certain circumstances, setting n 2 < n1 does give a better ex post payoff to the buyer. Following from propositions 1 and 2 we have the following proposition.

Proposition 2: The buyer prefers setting a number of bidders to proceed to the next round of auction ( n 2 ) over setting a reservation price if the condition in (2) holds.

Proof: By Lemma 2, setting a reservation price U > C1 yields the bidding strategy (A4). That bidding strategy is dominated by the strategy in a multistage setting given by (1) under the condition given in Proposition 1. Q.E.D

The intuition for this Proposition is that setting a reservation price is tantamount to truncating the cost distribution of the bidders. Condition (2) is one that specifies that the negative impact of reducing the number of bidders is less than the impact of truncating the cost distribution. Furthermore, one must also consider the information burden on buyers in setting the reservation price. Setting a good reservation price requires some information of the cost distribution. In contrast, setting the number of bidders does not require the seller to have such information. Setting the number of bidders that will proceed to the second round has an increased probability of a competitive bidding situation than the setting of a reservation price.

2.2.2.2 A reservation price is announced in the second stage

19

We now consider the case where a reservation price is announced before the second stage after an English auction is run in the first stage and the number of bidders ( n 2 ) was previously announced. In this type of auction mechanism, the first stage allows the buyer and all the sellers to estimate the n 2 +1st bidders cost. Thus, a reservation price made based on the observation of bids submitted in the first stage may be advantageous to the buyer.

In the first stage, the buyer should expect that all the bids submitted are close to n 2 +1st bidders cost. In the second stage, the upper bound of distribution of cost becomes Cn 2 +1 . The buyer announces a reservation price U in the second stage, which satisfies U < Cn 2 +1 . The second stage problem for bidder i whose cost is below U then becomes that of a single-stage auction with a reservation price, except that now the upper bound of cost distribution has changed. The equilibrium bidding strategy for bidder i in the second stage becomes that in (7). Assuming a uniform distribution of C i , we have f ( C i ) = 1 and F (U ) = U . The equilibrium bidding strategy for any bidder
U

Cn2 +1

then takes the form of equation (1).

2.2.3 Some numerical examples

The following numerical examples illustrate different winning bids the buyer is able to obtain in the two-stage auctions described above.

2.2.3.1 Comparison of the ex ante and ex post winning bids in a two-stage English-FPSB auction with (1) n 2 < n1 ; (2) n 2 = n1 and U; (3) n 2 < n1 and U

Table 1
Cases 1 2 3

C1 =0.10, C2 =0.20,
C 3 =0.30, C4 =0.40

C1 =0.10, C2 =0.20,
C 3 =0.40, C4 =0.75

C1 =0.10, C2 =0.30,
C 3 =0.80, C4 =0.90

20

Expected winning bid in an EnglishFPSB auction with

0.40

0.40

0.40

(0.40)

(0.40)

(0.40)

n 2 =3 ( n 2 =2)
1 E ( B *1 ) = E{C1 + (C4 C1 )} 3

( E ( B *1 ) = E{C + 1 (C C )} ) 1 4 1
2

Ex post winning bid in an English-FPSB auction with ( n 2 =2)

1 B *1 = C1 + (C 3 C1 ) 3 B *1 = C1 + 1 (C 3 C1 ) 2

0.20

0.32

0.37

n 2 =3

(0.20)

(0.25)

(0.45)

Expected winning bid in an EnglishFPSB auction with

0.40

0.40

0.40

(0.40)

(0.40)

(0.40)

n 2 =4 and U=0.8
(U=0.6)
1 B *1 = C1 + (U C1 ) 3

Ex post winning bid in an English-FPSB auction with

0.35

0.35

0.50

n 2 =4

(0.22)

(0.27)

(0.35)

and U=0.8 (U=0.6)

B *1 = C1 + 1 (U C1 ) k

Expected winning bid in an EnglishFPSB auction with

0.40

0.40

0.40

(0.40)

(0.40)

(0.40)

n 2 =3 and U=0.8 14
( n 2 =2 and U=0.6)
14

The expected winning bid can be derived from the proof of proposition 2 as

3 3 4 4 1 1 R k 4k k n1 k E ( B1 ) = E{(C1 + (C n 2 +1 C1 )){1 F (U ) (1 F (U )) } + (C1 + k (U C1 )) k F (U ) (1 F (U )) } 3 k =0 k k =1

21

Ex post winning bid in an English- FPSB auction with

0.20

0.33

0.45

n 2 =3

(0.20)

(0.25)

(0.35)

and U=0.8 15 ( n 2 =2 and U=0.6)

In Table 1, we first calculate the expected winning bids and then the actual winning bids for a two-stage English-FPSB auction with n 2 =3 and for n 2 =2. The ex post winning bid is significantly lower than the expected winning bid in all three cases with different simulated costs of bidders, except for case 3 when n 2 =2. We then calculate the expected and ex post winning bids in a two-stage English-FPSB auction with n 2 = n1 =4 and a reservation price U=0.8 or U=0.6. We next consider the case where the buyer adopts both setting n 2 =3 with a reservation price U=0.8 and n 2 =2 with a reservation price of U=0.616.

Even though the buyers ex ante expected winning bids are the same for these three different types of auctions, including setting only n 2 < n1 , setting only a reservation price with n 2 = n1 , and setting n 2 < n1 as well as a reservation price, the ex post winning bids are different for different auctions for all three cases. In these cases, we find that setting

n 2 < n1 weakly dominates the other two types of auctions in the ex post payoff to the
buyer. Also, in all three cases setting a reservation price U alone or setting a reservation price as well as n 2 < n1 does not produce great differences in the ex post winning bid.

When compared with setting a reservation price of U=0.6, setting n 2 =3 gives a better ex post winning bid in all cases except for that of case 3. The probability of receiving no

15

It is equal to

B* R (C1 ) = C1 +

1 if (U C1 ) k

U C n2 +1 , where k is the observed number of bidders that enter the

second stage or
16

B *R (C1 ) = C1 +

1 (C n2 +1 C1 ) n2

if U > C n +1 .
2

The particular combination we choose between n 2 and U is due to fact that the expected value of the ith smallest number of n random variables in a uniform distribution is i/(n+1). For example, if the buyer chooses n 2 =3, the expected upper bound of distribution and thus a reasonable reservation price becomes 0.8, which is the fourth bidders cost, and vice versa.

22

bids after establishing a reservation price is (1 U ) 1 . When the buyer reduces the
n

reservation price, the buyer also increases the probability of getting no bids. However, setting n 2 guarantees the buyer of a bid. This shows why the buyer may prefer setting

n 2 to setting a corresponding reservation price U; the efficiency of the auction increases

while the payoff from the auction may increase as well.

2.2.3.2 A comparison of the ex ante and ex post winning bids in a two stage FPSBFPSB auction with (1) n 2 < n1 ; (2) n1 = n 2 and U.

After trivial calculation, for all three cases as before, the expected winning bid in a FPSB-FPSB auction with n 2 =3 is equal to 0.40,17 the ex post winning bid in a FPSBFPSB auction with n 2 =3 is equal to 0.18,18 the expected winning bid in a FPSB-FPSB auction with n 2 =4 and U=0.8 is equal to 0.40, 19 and the ex post winning bid in a FPSBFPSB auction with n 2 =4 and U=0.8 is equal to 0.33.

The results show that in these cases the strategy of setting n 2 dominates the strategy of setting U in an FPSB-FPSB auction. Also, by comparing the ex post winning bids in an FPSB-FPSB auction with those in an English-FPSB auction with the same n 2 , we find that the actual winning bids in an FPSB-FPSB auction are strictly less than those in an English-FPSB auction for all cases. That is, information revelation in an English-FPSB auction does not help the buyer obtain a lower winning bid. In the FPSB-FPSB auction, the bidders in the second stage do not know their ranking among the other bidders and what the other sellers bid in the first stage, but they do know that the distribution has been truncated. This uncertainty in the face of a more competitive auction can lead to the lowest cost producer bidding lower than the cost of the second lowest cost producer. It, however, does raise the possibility of a less efficient auction.

17 18

See appendix E. See appendix E. 19 It follows from Lemma 2 after applying uniform distribution.

23

Conclusions

In this study, we have developed and analyzed models of single- and two-stage procurement auctions. In the two-stage auctions, upon the conclusion of the first stage, some bidders are eliminated and the remaining bidders may (or may not) be more informed of the cost distribution. The second stage of the auction determines the winner of the supply contract. We compare and contrast these procurement auctions with their single-stage counterparts. We find that there is a trade-off between the number of bidders allowed to proceed to the second stage and the extent to which the elimination of bidders reduces the variance in their cost distribution. Consequently, the use of multistage procurement auctions can be advantageous to the buyer when there are a few outliers in the cost distribution. Furthermore, we find that multistage auctions can be useful when the first stage provides information to the buyer and other sellers on the underlying cost distribution. Finally, we find examples where revealing information to the sellers of the first-stage auction can be counter to the interests of the buyer. Internet auctions, by opening up the number of types of auction mechanisms used, can change the nature of competition between suppliers. Careful deliberation of the procurement auction designer is required to know which options are most advantageous to the buyer.

24

References Aeppel, Timothy, 1999, Bidding E-nuts and E-bolts on the Net, Wall Street Journal, March 12. Athey, Susan, 2001, Single crossing properties and the existence of pure strategy equilibrium in games of incomplete information, Econometrica, Vol 69. 861-889 Branco, Fernando, 1997, The Design of Multidimensional Auctions. RAND Journal of Economics, Vol.28, 63-81. Budde, Jorg and Robert F. Gox, 1999, The Impact of capacity Costs on Bidding Strategies in Procurement Auctions, Review of Accounting Studies, 4-1. Bulow, J and J. Roberts, 1989, The Simple Economics of Optimal Auctions, Journal of Political Economy, 97(5), 1060-1090. Che, Y-K, 1993, Design Competition through Multidimensional Auctions, RAND Journal of Economics, 24, 668-680. Chiesa, Gabriella, 2003, Multi-unit Procurement Auctions and the Effects of Mergers, working paper, University of Bologna. Gallien, Jeremie and Lawrence M. Wein, 2001, A Smart Market for Industrial Procurement with Capacity Constraint, working paper, MIT Sloan School of Management. Hansen, Robert G, 1988, Auctions with Endogenous Quantity, RAND Journal of Economics, Vol.19, No.1, 44-58. Kafka, S., B. Tempkin, and L. Wegner, 2000, B2B Auctions Go Beyond Price, Forrester Research Inc. report, Cambridge, MA. Klein, S and R. OKeefe, 1999, The Impact of the Web on Auctions: Some Empirical Evidence and Theoretical Considerations, International Journal of Electronic Commerce, 3(3), 7-20. Klemperer, Paul, 1999, Auction Theory: a Guide to the Literature, Journal of Economic Surveys, Vol. 13, No.3, 227-286. Klemperer, Paul, 2000, Why every economist should learn some auction theory, forthcoming in M. Dewatripont, L. Hansen, and S. Turnovsky, Advances in Economics and Econometrics, Cambridge. Krishna, Vijay, 2002, Auction Theory, Academic Press.

25

Lucking-Reily, David, 2000, Auctions on Internet, Journal of Industrial Economics, Vol 148. McAfee, Preston R. and John McMillan, 1987, Auctions and Bidding, Journal of Economic Literature, Vol. XXV, 699-738. McAfee, Preston R. and John McMillan, 1988, Search Mechanisms, Journal of Economic Theory, 44, 99-123 Milgrom, Paul, 1989, Auctions and Bidding, Journal of Economic Perspectives, Volume 3, No.3, 3-22. Milgrom, Paul, 2000, Putting Auction Theory to work: the Simultaneous Ascending Auctions, Journal of Political Economy, 108, 245-272. Milgrom, Paul, 2004, Putting Auction Theory to Work, Cambridge University Press Milgrom, Paul and Robert J. Weber, 1982, A Theory of Auctions and Competitive Bidding, Econometrica, 50, 1089-1122. Myerson, Roger B., 1981, Optimal Auction Design, Mathematics of Operations Research, Vol. 6, No.1, 58-73. Pinker, Edieal, Abraham, Seidmann and Yaniv, Vakrat, 2001a, Using Transaction Data for the Design of Sequential, Multi-unit Online Auctions, working paper, University of Rochester, No. CIS00-03. Pinker, Edieal, Abraham, Seidmann and Yaniv, Vakrat, 2001b, The Design of Online Auctions: Business Issues and Current Research, working paper, University of Rochester, No. CIS01-05. Reny, Philip, 1999, On the existence of pure and mixed strategy Nash Equilibria in discontinuous games, Econometrica, Vol. 67, 1029-1056. Riley, John G. and William F, Samuelson, 1981, Optimal Auctions, The American Economic Review, June, 381-392. Roth, Alvin E and Axel, Ockenfels, 2003, Late and Multiple Bidding in Second Price Internet Auctions: Theory and Evidence Concerning Different Rules for Ending an Auction, CESIFO working paper No.992, Harvard University. Vincent, Daniel, 1995, Bidding off the wall: why reserve price may be kept secret, Journal of Economic Theory, Vol. 65, 575-584. Vickrey, William, 1961, Counterspeculation, Auctions, and Competitive Sealed Tenders, The Journal of Finance, 16, 8-37.

26

Wellman, M. P., W.E. Walsh, P. R. Wurman and J. K. Mackie-Mason, 1999, Auctions Protocols for Decentralized Scheduling, University of Michigan, forthcoming in Games and Economics Behaviour.

Appendix A
One-stage FPSB procurement auction We examine an auction where sellers provide one bid to the buyer being unaware of what other sellers are bidding. The buyer opens the bids simultaneously and the lowest bid wins. Maximizing the expected profit, bidder is problem can be written as

MAX Bi ( Bi C i )(1 F ( B 1 ( Bi ))) n 1

(A1)

where (1 F ( B 1 ( Bi ))) n 1 is the probability that the bidder wins the auction with a bid of Bi. The first order condition for the above problem is20
(1 F ( B 1 ( Bi ))) n 1 + ( Bi C i )(n 1)(1 F ( B 1 ( Bi ))) n 2 ( f ( B 1 ( Bi ))) d ( B 1 ( Bi )) = 0 dBi

which can be rewritten as,

(1 F (C i )) n 1 B' (C i ) + ( B(C i ) C i )(n 1)(1 F (C i )) n 2 ( f (C i )) = 0

(A2)

B' (C i ) + B(C i )

(n 1)( f (C i )) (n 1)( f (C i )) = Ci . 1 F (C i ) 1 F (C i )

Let A(C ) = (n 1) F ' (Ci ) , i

1 F (Ci )

B ' (C i ) + B (C i ) A(C i ) = C i A(C i ).

Ci

A( Ci ) dCi to each item in the above equation, we have Multiplying the integration factor e 0
B ' (C i )
A ( Ci ) dCi e 0 +
Ci

B (C i ) A (C i )

A ( Ci ) dCi e 0 =

Ci

Ci A(Ci )

A ( Ci ) dCi e 0 .

Ci

We then have, d( B (Ci ) Since

A ( Ci ) dCi e 0 )=
Ci

Ci A(Ci )

A ( Ci ) dCi e 0 .

Ci

A(C )dC
i

= ln(1 F (Ci ))

n 1

+ K'

A( Ci ) dCi = we have e 0 (1 F (C i )) n 1 + K , where both K and K

Ci

denote integration constants.

20

The second order condition is shown in appendix B.

27

After changing variables, we can obtain the following solution for B(x), where x [0,M] , from now on let y denote the variable Ci

B( x)(1 F ( x)) n 1 = y(n 1)( f ( y))(1 F ( y)) n 2 dy + K .

0

Now, let U=y and dV = ( f ( y ))(1 F ( y )) n 2 dy we then have dU=dy, and V = 1 (1 F ( y )) n 1 . n 1 Integrating by parts yields:

( n 1) y ( f ( y ))(1 F ( y )) n 2 dy = [(n 1) y
0

x 1 1 x (1 F ( y )) n 1 ]0 (n 1) (1 F ( y )) n 1 dy 0 n 1 n 1

x B( x)(1 F ( x)) n1 = [ y(1 F ( y)) n1 ]0 (1 F ( y)) n1 dy +K 0

Therefore, the equilibrium solution for Bi when x=Ci will be:

B (C i ) = C i
*

Ci

(1 F ( y )) n 1 dy
n 1

(1 F (C i ))

K (1 F (C i )) n 1

(A3)

which is equation (2), where K is an integration constant. As the number of bidders approaches infinity then each bidders bid will approach their cost. That is, Lim n B (C i ) = C i . We then have Lim
K = Lim n (1 F (C i )) n 1

Ci

(1 F ( y )) n 1 dy

(1 F (C i )) n 1

. By applying LHopitals rule,

Lim n

(1 F (C i )) n 1 K = Lim n (1 F (C i )) n 1 (n 1)(1 F (C i )) n 2 ( f (C i )) , = Lim n 1 F (C i ) =0 (n 1)( f (C i ))

when f(Ci) is locally bounded. Since (1 F (C i )) n 1 is not bounded, in order for the Lim n

K = 0 we must have that Limn K = 0 . Also, in order to have (1 F (C i )) n 1

(1 F ( y )) n 1 dy K 0 0 satisfied. Since the bidding strategy (1 F (C i )) n 1 (1 F (C i )) n 1
Ci

B * (C i ) C i we must have

is a monotonically increasing function of cost, we then must have the condition

dB * (C i ) d k d 0 (1 F ( y )) dy = 1 { }+ { } > 0 satisfied. n 1 dC i (1 F (C i )) n 1 dC i dC i (1 F (C i ))
n 1 Ci

For the uniform distribution case the equilibrium bidding strategy is:

28

B (C i ) = C i
*

Ci

y n 1 ) dy K M + C i n 1 C i n 1 (1 ) (1 ) M M (1

We can rewrite the above equation as:

B * (C i ) = C i + C M M (1 i ) n M n K 1 + C i n 1 C i n 1 (1 ) (1 ) M M

From above we have the condition Limn B(Ci ) = Ci which implies

K Lim n B(C i ) = C i + Lim n M n

C (1 i ) n 1 M

= Ci

. In order to have

Lim n

M n =0 Ci n 1 (1 ) M K

it must be the

case that K = M / n .
This simplifies the equilibrium bidding strategy for any bidder i in static one stage procurement auction to:21
B * (C i ) = C i + 1 ( M Ci ) n

(A4)

* * From the above we can see the comparative statics B = 1 ( M C i ) < 0 and B = 1 > 0 , M n n n2

which implies that with more bidders and with denser cost distributions, the equilibrium bid for each seller is lower. However, the rates of change of B* (Ci ) with respect to an increment of n and M are different and depend on one another. The profit margin for any buyer i is defined as
B * (C i ) C i = ( M C i ) / n , which is a decreasing function of bidder is cost. That is, the higher is

the cost of bidder I, the closer the bid is to that cost. Notice that B(C i ) : [0, M ] R + is an increasing and continuous function. Thus, in equilibrium the bidder with the lowest cost submits the lowest bid and wins the auction.

McAfee and McMillan (1988) proposed that the expected payment of the buyer to the winning seller is the expected value of a function J (C1 ) , which is defined as J (C1 ) = C1 + F (C1 ) / f (C1 ) . Note that the buyer does not know the exact value of

C1 but the expected value of J (C1 ) . The

21

In order have a monotonic increasing function of B * (C i ) the condition 1 1 > 0 must be satisfied,
n

which is the case whenever n 2 .

29

expected value of F (C1 ) / f (C1 ) if equal to ( M C i ) / n in our derived equilibrium bidding strategy.

Appendix B
Checking the Second Order Condition

In order to show that the first order condition gives the minimum solution for a bidding function, here we also check the second order condition to show that we are able to obtain a local minimum for B(Ci).

Totally differentiating the first order condition with respect to B(Ci) gives:

B' ' (C i )(1 F (Ci )) n 1 + (n 1)(1 F (Ci )) n 2 ( f (C i )) B' (Ci ) + B' (Ci )(n 1)(1 F (C i )) n 2 ( f (Ci )) + ( B (C i ) C i )(n 1)[(n 2)(1 F (C i )) n 3 f (C i ) 2 + (1 F (C i )) n 2 ( f ' (C i ))]

= B' ' (Ci )(1 F (Ci )) n1 + 2(n 1)(1 F (Ci )) n2 ( f (Ci )) B' (Ci ) + ( B(Ci ) Ci )(n 1)[(n 2)(1 F (Ci )) n 3 f (Ci ) 2 + (1 F (Ci )) n2 ( f ' (Ci ))]
As a special case of a uniform cost distribution, let B(Ci ) = Ci + 1 ( M Ci ) , n then B ' (C ) = 1 1 and B' ' (C i ) = 0 , the second order condition can then be simplified to i
n

2(n 1)(1

Ci n 2 1 1 1 C 1 ) ( )(1 ) + ( M Ci )(n 1)(n 2)(1 i ) n 3 2 M M n n M M 1 C = (n 1) 2 (1 i ) n 3 ( M Ci ) M M

In order for the objective function to attain a local maximum, the second order condition has to satisfy the non-positive condition. This condition is satisfied when n 1 .

Appendix C Proof of Lemma 1

Rewrite bidder is problem as

30

n2 1 n1 1 n1 1 k 1 f f MAX B f , B s ( Bis Ci )(1 G ( B 1s ( Bis ))) n2 1 { F ( B 1 f ( Bi f )) k } k (1 F ( B ( Bi ))) i i k =0 s.t Bis Bi f 0

Ci Bis 0 where Ci [0, M ]

The Lagrangian is then,

n 2 1 n1 1 n1 1 k f 1 f L = ( Bis Ci )(1 G ( B 1s ( Bis )))n2 1 { F ( B 1 f ( Bi f ))k } + 1 ( Bi f Bis ) + 2 ( Bis Ci ). (1 F ( B ( Bi ))) k =0 k n2 1 n1 1 n1 1 k 1 f f Let W F ( B 1 f ( Bi f )) k (1 F ( B ( Bi ))) k k =0

The Kuhn-Tucker conditions for this problem are then the following:

LB s = (1 G ( B 1s ( Bis ))) n2 1W + ( Bis Ci )(n2 1)(1 G ( B 1s ( Bis ))) n2 2 ( g ( B 1s ( Bis )))

i

1 W 1 + 2 = 0 Bis '

LB f = ( Bis Ci )(1 G ( B 1s ( Bis ))) n2 1W '

i

1 + 1 = 0 Bi f '

1 ( Bi f Bis ) = 0

2 ( Bis C i ) = 0

where we have,
n1 1 n1 1 n1 2 n1 3 n1 2 W ' = { f (Ci )] + ... [(n1 2)(1 F (Ci )) ( f (Ci )) F (Ci ) + (1 F (Ci )) 1 (n1 1)(1 F (Ci )) ( f (Ci )) + 0 n1 1 n1 n 2 1 + ( f (Ci )) F (Ci ) n2 1 + (n2 1)(1 F (Ci ))n1 n2 F (Ci ) n2 2 f (Ci )]. n 1 [(n1 n2 )(1 F (Ci )) 2

There are altogether four cases to consider for this maximization problem. (I). 1 0, and

2 0 . 2 0 .

Then the solution gives Bi f = Bis = C i , which gives the expected payoff to bidder i zero. (II). 1 = 0, and

The expected payoff to bidder i is also zero. (III).

1 0, and 2 = 0 .

In this case, condition Bi f Bis 0 is binding and condition Bis C i 0 becomes Bis C i > 0 . Therefore, a feasible solution of Bi f = Bis > C i is expected to achieve. (IV).

1 = 0, and 2 = 0 .

The above condition implies B i f > B is and Bis > Ci . However, if a bidder chooses Bi f = B is > C i , it increases the probability of advancing without reducing the expected payoff to bidder i. Therefore, solution 1 = 0, and

2 = 0 is inferior to 1 0, and 2 = 0 . Also, when 1 = 0, and 2 = 0 ,

31

LB f becomes LB
i

= ( Bis Ci )(1 G ( B 1s ( Bis ))) n2 1W ' = 0 . First, from condition 2

= 0 we

know ( Bis C i ) 0 . As long as bidder is cost are not equal to zero then (1 G ( B 1s ( Bis ))) n2 1 0 . The only solution then is to have W ' = 0 . As achieve any feasible solution for Bi .
f

0 < W ' < 1, and when 1 = 0, and 2 = 0 we do not

Now, rewriting the Kuhn-Tucker conditions:

LB s = Bis ' (1 G (Ci )) n2 1W + ( Bis Ci )(n2 1)(1 G (Ci )) n2 2 ( g (Ci ))W 1 Bis ' = 0
i

LB f = ( Bis C i )(1 G (C i )) n2 1W '+ 1 Bi f ' = 0

i

Bi Bis = 0
f

From LB s = 0 and LB f = 0 , we get the following equation after cancelling 1 ,

i i

Bis ' (1 G (Ci )) n2 1W + ( Bis Ci )(n2 1)(1 G (Ci )) n2 2 ( g (Ci ))W +

Bis ' s ( Bi Ci )(1 G (Ci )) n2 1W ' = 0 Bi f '

Bis '+ Bis (n2 1)(1 G (Ci )) n2 2 ( g (Ci ))W + (1 G (Ci )) n2 1W ' (n 1)(1 G (Ci )) n2 2 ( g (Ci ))W + (1 G (Ci )) n2 1W ' = Ci 2 n2 1 (1 G (Ci )) W (1 G (Ci )) n2 1W

n2 2 Now let A1 (Ci ) = (n2 1)(1 G (Ci )) ( g (Ci )) (1 G (Ci )) n2 1

and

A2 (Ci ) =

W ' , then the above differential W

equation can be written as,

Bis '+ Bis [ A1 (C i ) + A2 (C i )] = C i [ A1 (C i ) + A2 (C i )]

[ A1 ( Ci ) + A2 (Ci )]dCi to each item in the above equation gives, Multiplying the integration factor e 0
[ A1 ( Ci ) + A2 ( Ci )] dCi [ A1 ( Ci ) + A2 ( Ci )]dCi d ( B e 0 ) = C i [ A1 (C i ) + A2 (C i )]e 0 s i
ci Ci

Ci

And we have e 0

Ci

[ A1 ( Ci )+ A2 ( Ci )] dCi

= (1 G (Ci )) n2 1W + K , where K denotes an integration constant.

After changing variables, we can obtain the following solution for B(x), where x [0,M],

B ( x ){(1 G (Ci )) n2 1W } = y[(n2 1)(1 G ( y )) n2 2 ( g ( y ))W ( y ) + (1 G (Ci )) n2 1W ' ( y )]dy

0 x = [ y (1 G ( y )) n2 1W ( y )]0 (1 G ( y )) n2 1W ( y )dy + K 0 x

Finally, we are able to obtain the equilibrium bidding strategies:

32

Bi f

FPSB FPSB*

= Bis

FPFB FPSB*

n2 1 n1 1 n1 1 k { F ( y ) k }dy (1 F ( y )) k K = 0 k + = Ci 0 n2 1 n2 1 n n 1 1 (1 F (Ci )) n1 1k F (Ci ) k (1 F (Ci )) n1 1 k F (Ci ) k } (1 G (Ci )) n2 1{ 1 1 (1 G (Ci )) n2 1{ k k k =0 k =0 Ci

(1 G( y))

n2 1

As a special case, let

n1 = n 2 , then G(.)=F(.), and the probability of advancing becomes equal to

one. Then the above equilibrium bidding strategies become,

B (Ci ) = Ci
*

Ci

(1 F ( y )) n1 1 dy

(1 F (Ci )) n1 1

K (1 F (Ci )) n1 1

Thus the integration constant should take value of M/ n1 .

Appendix D
Proof of Lemma 2

By applying Taylors expansion we can rewrite the objective function as:

MAX Bi ( B i C i ){1 F (U ) F ( B 1 ( B i ))} n 1

The first order condition then becomes:

(1 F (U ) F (C i )) n 1 B ' (C i ) + ( B (C i ) C i )( n 1)(1 F (U ) F (C i )) n 2 ( F (U ) f (C i )) = 0

Note that in the above first order condition, B 1 ( Bi ) [0, U ] .

B ' (C i ) + B (C i )

(n 1)( F (U ) f (C i )) (n 1)( F (U ) f (C i )) = Ci 1 F (U ) F (C i ) 1 F (U ) F (C i )

Let A(C i ) =

(n 1) F (U ) F ' (C i ) , 1 F (U ) F (C i )

Since

B ' (C i ) + B (C i ) A(C i ) = C i A(C i )

A(C )dC
i

= ln(1 F (Ci ))

n 1

+ K'

A( Ci ) dCi = we have e 0

Ci

(1 F (Ci ))n 1 + K , where both K and K

denote some arbitrary constant.

Therefore, after changing variables, we can obtain the following solution for B(x) from (A4), where x [0,U] , from now on let y denote variable Ci

B( x)(1 F (U ) F ( x)) n 1 = y (n 1)( F (U ) f ( y ))(1 F (U ) F ( y )) n 2 dy + K

0

33

Now, let U=y and dV = ( F (U ) f ( y ))(1 F (U ) F ( y )) n 2 dy then we have dU=dy, and

V = 1 (1 F (U ) F ( y )) n 1 , integrating by parts gives: n 1
x x 1 1 x (1 F (U ) F ( y )) n 1 ]0 ( n 1) (1 F (U ) F ( y )) n 1 dy 0 n 1 n 1

( n 1) y ( F (U ) f ( y ))(1 F (U ) F ( y )) n 2 dy = [(n 1) y
0

x B ( x )(1 F (U ) F ( x )) n 1 = [ y (1 F (U ) F ( y )) n 1 ] 0 (1 F (U ) F ( y )) n 1 dy +K 0

Therefore, the equilibrium solution for Bi when x=Ci will be:

B
*R

(C ) = C
i i

Ci

(1 F (U ) F ( y ))n 1 dy
n 1

(1 F (U ) F (Ci ))

K . (1 F (U ) F (Ci ))n 1

Analogous to Appendix A, as the number of bidders approaches infinity and each bidders bid approaches their cost. That is, Lim n B (C i ) = C i . We have
Lim n K = Lim n (1 F (U ) F (C i )) n 1

Ci

(1 F (U ) F ( y )) n 1 dy

(1 F (U ) F (C i )) n 1
Ci 0

By applying LHopitals rule, Lim n

(1 F (U ) F ( y )) n 1 dy

(1 F (U ) F (Ci )) n 1

becomes

Limn

(1 F (U ) F (C i )) n 1 1 F (U ) F (C i ) = Limn = 0 , when n2 (n 1)( F (U ) f (C i )) (n 1)(1 F (U ) F (C i )) ( F (U ) f (C i ))

*

f(Ci) is locally bounded. Also, in order to have B (C i ) C i we must have

K (1 F (U ) F (C i )) n 1

Ci

(1 F (U ) F ( y )) n 1 dy

(1 F (U ) F (C i )) n 1

0 satisfied.

Appendix E
(Equilibrium bidding strategy for FPSB-FPSB auction with M=1 with uniform distribution)

n1 =4, n 2 =3, and

From Appendix C, the equilibrium bidding strategy for a two-stage FPSB-FPSB auction with number of bidders in two stages as

n1 =4 and n 2 =3 can be now written as:

34

Ci f FPSB FPSB* s FPFB FPSB*

Bi

= Bi

= Ci

(1 G( y)) { k (1 F ( y ))
2 0 k =0 2

3 k

F ( y ) k }dy + (1 G (Ci )) 3 {
k =0 2

3 3 k k (1 G (Ci )) 2 { (1 F (Ci )) F (Ci ) } k =0 k

M / n1 3 3 k k k (1 F (Ci )) F (Ci )

Applying Taylors expansion we can rewrite the above bidding strategies as:
Ci f FPSB FPSB * s FPFB FPSB *

Bi

= Bi

= Ci

(1 G( y))
0

(1 F ( y ) 3 )dy +

(1 G (Ci )) 2 (1 F (Ci ) 3 )

M / n1 (1 G (Ci )) 2 (1 F (Ci ) 3 )

Now we apply uniform distributions. In the second stage of the auction, the upper bound of the expected distribution G(.) is expected to equal to C n 2 +1 , which is

C4 . Since in a uniform

distribution, the ith smallest number of n numbers is distributed as Beta(I,n-i+1) distribution, which has mean i/(n+1), the expected value of

C4 is equal to 4/5.

The expected bidding strategy bidder 1 adopts becomes,

f FPSB FPSB* 1 s FPFB FPSB* 1

=B

5y 2 ) (1 y 3 )dy 4 0.25 = C1 0 + 5C1 2 5Ci 2 3 3 (1 ) (1 C1 ) (1 ) (1 C1 ) 4 4 25 1 1 25 5 C16 + C15 C14 + C13 C12 + C1 0.25 96 2 4 48 4 + = C1 10 10 25 25 10 10 25 25 1 C13 C1 + C14 + C12 C15 1 C13 C1 + C14 + C12 C15 4 4 16 16 4 4 16 16

C1

(1

Since the expected value of C1 is equal to 0.2, then the above equilibrium bidding strategy
yields the expected winning bid equal to 0.4.

For three cases in our numerical example, when from the above equation is equal to 0.18.

C1 is equal to 0.1, the actual winning bid derived

35