EC 307: Economic Policy in the UK

1. EC 307: Economic Policy in the UK Week 13: Competition

2. Competing suppliers • Original approach was single supplier, • Non-competitive contracts • Cost+ (esp. for R&D) or cost-based pricing • Poor incentive properties, heavy information requirements • Demand focus (jobs, technology, cheap (local) supply costs, long-term relationships, ‘sales on wider markets’ • Competition began to come in mid-80’s • Trade-off benefits against demand focus • Narrow VFM criteria • Competition for contracts • Prime contractor model for risk transfer • Competition for subcontracts • Separate R&D, production • Fixed price, firm price, target/incentive payment schemes • Performance-driven (functional) specification EUK Lecture 3

3. Outline • General discussion of competition • Monopoly model shows information rent, hold-up/foreclosure problems, static deadweight loss: can competition do better? • Competition might also offer help in finding the best supplier, motivating R&D and other improvements, spreading public patronage, etc. • One-shot auctions • Basics of auction design • The importance of entry • Collusion • Multiple winners • Ongoing and supply-side relationships - multiple-sourcing • Renegotiation • Public procurement size, discrimination • the EC Procurement Environment • MEAT EUK Lecture 3

4. The competitive sourcing problem • Decision 1: how many (and which) suppliers to use? • Decision 2: how to design contracting arrangements to maintain competitive pressures • Control (design and production) costs • Control profits • A theoretical wilderness – scads of oligopoly models; contract models; allocation models • Symmetric situations: auctions, markets • Asymmetric situations due to incumbent, technological, IPR, political (e.g. national champion) advantage • Markets: separate decisions about how many suppliers, type of contract: analogous to regulatory models • How many firms? • More = competition, product diversity, reduced information asymmetry • Fewer = less duplication of fixed cost EUK Lecture 3

5. More on competition problem • Information asymmetry in markets: • Correlation: make i’s payment depend on j’s price offers, reports, etc. -> benchmarks and yardsticks • Scale: more suppliers -> better chance of finding a low-cost one, less stable collusion • When duplication costs are low (e.g. when all suppliers sell on private or other markets), this effect may dominate • Otherwise, the government may wish to create markets • Tendering • By far the most common method • Sensitive control of mechanism design • Complex legal and regulatory structure – the ground rules (both de facto and de jure) are clear and common knowledge • An excellent excuse to use auction analysis :-) • Some useful history: (e.g. Szymanski, S. (1996) ‘The Impact of Compulsory Competitive Tendering on Refuse Collection Services’, Fiscal Studies, 17(3), 1–19) EUK Lecture 3

6. Ingredients of tender process (life-cycle) • Determination of requirements • Business case for procurement • [pre-competitive engagement] • Tender specification • Bidder qualification • (functional) description of what is to be procured, indicative price, etc. • Evaluation scheme • Sample contract • Evaluation of bids • Award of contract and ‘debriefing’ • Negotiation • Contract management • Acceptance, evaluation EUK Lecture 3

7. Auctions… a brief review 4 basic types of ‘reverse’ auctions • Open-outcry - descending (English) and ascending (Dutch) • Sealed-bid – first-price and second-price • Exotic variants - multiple objects, sequential, menu, all-pay, 2-sided… Values (costs) • Private – cost is personal; if uncertain, private information gives no clue as to others’ information/cost • Common – cost is common, but private information differs, so i’s estimated cost would be affected by knowing j’s signal • General costs (general – each receives private signal, but cost to each is a function of all signals). Special case: affiliated costs Variables • Number, type of objects; forward or reverse • Bidder information (and correlation): private- to common-costs; independent to affiliated/correlated EUK Lecture 3

8. Some equivalences and ‘results’ • English auction (strategy = when to stop bidding) equivalent to second-price sealed bid under certain conditions • Dutch auction (strategy = when to bid) exactly equivalent to first-price sealed bid • Revenue Equivalence – under reasonable conditions (mainly, independent information), many standard (and non-standard) types of auction give the seller (and buyers) the same expected outcome. • Affiliation – if information is affiliated (i’s higher expectations make j’s higher expectations more likely) then descending auctions are ‘better’ for buyers. • Entry – auctions attract different numbers and kinds of entrant – and thus differ in performance. • Collusion – different auction types offer different possibilities for collusion • Reality check – entry, collusion have an enormous influence on success. EUK Lecture 3

9. break EUK Lecture 3

10. The Revenue Equivalence Theorem • Setup: n risk-neutral bidders with private cost signals drawn independently according to a common, atomless, strictly-increasing distribution • Bid for a single contract. • If two auction mechanisms have the properties that: • the object goes to the bidder with the lowest signal (cost) • The highest-cost bidder expects zero surplus, • … then both mechanisms give the auctioneer and each bidder (conditional on cost signal) the same expected payoff • Use of the RET: • Many auction forms are equivalent and can thus be analysed in terms of the (obvious) outcome of the second-price sealed bid auction: • Dominant strategy is to bid true cost • Object goes to lowest-cost bidder at second lowest cost EUK Lecture 3

11. Marginal expenditure interpretation • Optimal auction buys from bidder with lowest marginal expenditure (not necessarily lowest cost!) – shows how to set reservation price • Suppose a monopsonist faces a single seller with unknown cost (reservation price) c, drawn from a distribution F (density f) on an interval [c-, c+]. If he offers p in this interval, probability of buying or average purchases over many transactions is probability that seller’s cost is less than the price: F(p). Thus the curve F(p) is a supply curve. Working with the inverse supply curve (p(q) = F-1(q) in the usual way, we can construct the associated marginal revenue curve: EUK Lecture 3

12. Marginal Expenditure 2 • Optimal auctions buy from bidders with lowest marginal expenditure – ideal is to set ME = marginal opportunity cost of not buying. In this way, we can extend the analysis to sequential or repeated auctions (by taking careful account of marginal opportunity cost of (not) buying today. • Note: bidder with lowest ME may not be bidder with lowest cost or lowest signal: suppose there are 2 bidders, with costs uniformly and independently distributed on [ai, 1+ai] (i=1,2). Marginal expenditures are: MEi(c) = 2c-ai for c’s that both types could observe, ME is lower for higher cost bidder (higher ai) – Motivates use of inefficient auctions. • Set reservation price = price corresponding to ME = opportunity cost of not buying. EUK Lecture 3

13. Non-independent information • A revelation auction: suppose 2 bidders (i  {1, 2}) get signals ti = H or L; • Joint distribution is f(H, H) = f(L, L) = 1/3; f(H, L) = f(L, H) = 1/6. • Bidder i’s actual cost is the known function ci(t1, t2) • The buyer can use the following ‘auction:’ • Ask 1 and 2 to make preliminary bids b1 and b2; • If b1 = b2, pay each bidder the amount M; • Otherwise, ask each bidder to pay the amount 2M; • In either case, buy the object from the bidder i with the lowest value of ci(b1, b2) at that price; i.e. price = smallest ci(b1, b2). • If M is big enough, telling the truth (bi = ti) is a Nash equilibrium. • Consider payments from first round: • A player who tells the truth (with a truthful opponent) gets M with probability 2/3 (conditional on ti) and pays 2M with probability 1/3: expected value = 0. • A liar gets M with probability 1/3, pays 2M with probability 2/3: expected value = -M. • First round essentially forces bidders to reveal costs. • Then buyer offers a price equal to the cost (< marginal expenditure) of the ‘winner.’ • There may be untruthful equilibria: • each seller can bid bi = H whatever the signals (getting constant M from round 1) • Each gets the high price ci(H, H) • But there are more complex mechanisms where truth is the only equilibrium. EUK Lecture 3

14. Linkage and Winner’s curse • Tie winning offer as closely as possible to winner’s information – e.g. disclose all relevant information to all bidders. • With affiliation, risk neutral buyer: descending > second-price sealed-bid > first-price sealed-bid auction. Why? Winner earns information rent. Affiliation makes information “less private” – price depends more on winner’s information (via affiliated 2nd lowest cost). Winner has less information rent, lower expected profit, lower expected fee. • Optimal reservation price is set where the ME of a bidder with that cost = buyers’ utility from not buying. • With independent private costs, this is independent of number of bidders; each bidder’s ME is independent of others’ and reservation price is much less than buyer’s value for not buying. • With affiliated costs more bidders means less variance in estimate of each’s cost conditional on others’ information  flatter ME curves  more bidders have ME < buyer’s value. Thus, optimal reservation price rises with n; in the limit = seller’s value for keeping the object (like a competitive price!) • Winner’s curse: winner is the bidder most likely to have underestimated cost  bidder’s should inflate their bids – a particular problem with common costs. • With affiliation, ascending auctions give buyer lower prices. • Standard explanation (open auction reduces winner’s curse) is wrong • Same result with private (affiliated) costs, where no winner’s curse; does not happen with independent common-cost auctions. • True story: can infer others’ private information from their ‘quitting point’ so a descending auction has less ‘bad news’ at the moment of winning – bidders more aggressive. Question is whether this compensates for reduced winner’s curse. RET proves there is no net effect for e.g. independent signal common cost case. • Bidder’s may fail to account for Winner’s curse, so sealed bid may be better. • Recently, electronic ‘open auction’ added to UK Calls for Tender. EUK Lecture 3

15. Entry is critical: costs • Private costs: Under conditions of RET (except costly entry), socially optimal entry results when res. price = buyer’s opportunity cost. • Social value of bidder i’s participation = prob(i wins)*[c(2) – ci] – exactly i’s expected profit from entering 2PSB. With free entry, reservation price = opportunity cost of supply minimises expected fee. Better still is a series of ascending auctions with rising reservation prices: • Try to sell at a low reservation price; • If fails, repeat with a higher reservation (more entry) until sold • Common costs: Optimal n=1. Even E(fee) can be increasing in n – in common cost setting lower signal does not imply lower ME. • Example: bidder i = 1,2,3 observes ci drawn iid from uniform distribution on [0, 1], and common cost is c* = min{ci}. • Buy from 1 uninformed bidder: pay E(min (c1,c2,c3) = ¼ • Buy from 1 informed bidder: set res. = 1/3 (lowest ME, since bidder who observes 1 expects min (c2, c3) = 1/3). • Buy from 2 informed bidders, get 5/12 • Buy from all 3, get E(second highest signal) = ½. • May be best to run inefficient auction to encourage entry EUK Lecture 3