Are procurement auctions letting us down?

In the European Union, the purchase of goods and services by the public sector accounts for 14% of its GDP. In such an important sector, it is crucial to use proper purchasing mechanisms to ensure an efficient use of taxpayers' money. Therefore, the European Union encourages the use of auctions for three main reasons: they can (i) create competition, (ii) lead to a more efficient use of resources, and (iii) mitigate potential favoritism.

One of the most popular mechanisms is the first-price auction. Interested firms submit a price for which they are willing to carry out the tendered task. The firm submitting the lowest price is awarded the contract and receives its bid as compensation. The popularity of this format derives from its desirable properties: since bidders do not know their competitors' bids, they will not ask for prices much higher than their costs because this increases the risk of losing the auction. Hence, competition brings down prices. Firms with low costs are likely to win: they can submit low bids as they can make a profit even at low prices.

Many procurement markets see some firms winning systematically more often than others. Does that imply that these firms are the ones with the lowest costs? The properties of auctions outlined above may suggest this: if a firm wins more auctions than its competitors, this firm should have the lowest costs and its dominance is desirable. Unfortunately, the story is not that simple.

The value of winning depends not only on firm-specific factors. Often, there are additional components that affect all firms equally, such as potential revenues generated by the service. If these revenues are unknown before bidding, firms will obtain some information, for instance, by hiring experts that provide an estimate. If firms use different sources of information, each firm holds some information privately that could also help other firms to estimate future revenues. One important insight of auction theory is that this setting features the winner's curse: the winner most likely overestimated the revenues because all other firms asked for a higher price. This induces firms to bid more cautiously.

Can the winner's curse explain that some firms win more often than others? The answer is yes. If a firm has access to more precise information, it is affected less by the winner's curse because it has more accurate knowledge of the object's value. Firms holding less precise information, however, will ask for high prices because they fear that their information may be incorrect. This intuition suggests that firms with precise information will win more auctions. When an informational advantage leads to a firm's dominance, the winning firm might not be the cost-efficient one.

In many industries, incumbents or former monopolists that have access to superior information participate in auctions. Since these firms are larger and more experienced, they might be both more cost efficient and better informed. Hence, to assess a market's performance it is important to understand why a firm is dominant. Is it cost-efficiency or access to superior information?

In a recent paper with Stefan Weiergraeber, we build the model underlying the previous arguments. Building on the model, we assess empirically why the former state monopolist Deutsche Bahn (DB) is dominant in the German market for short-haul railway passenger services - even 20 years after the introduction of auctions to procure the transportation services.

We find that DB has an advantage over its competitors due to superior information about ticket revenues. Although DB has lower costs in some cases, its informational advantage substantially contributes to its dominance. Our results indicate that regulating the access to information can improve the performance of procurement auctions resulting in a more efficient use of taxpayers' money.

(Builds on Weiegraeber and Wolf, Bidder Asymmetries in Procurement Auctions. Information vs. Efficiency, 2018.)