Adapted from “Negotiations Versus Auctions in Procurement,” first published in the Negotiation newsletter.
When developing procurement contracts, when should you hold an auction, and when should you negotiate? In a study of more than 4,000 private-sector construction contracts in Northern California between 1995 and 2000, researchers Patrick Bajari, Robert McMillan, and Steven Tadelis examined the differences between projects that were directly negotiated versus those that were up for auction. The researchers found that fixed-price contracts were much more likely to be transacted through auctions, while “cost plus” contracts (in which the supplier charges direct costs plus a negotiated profit margin) were virtually all negotiated.
Anecdotal discussions with procurement executives for very large corporations suggest a twist on this result. These executives argue that auctions are not needed for the simplest of commodities, since simultaneous negotiations have already succeeded in getting suppliers to sharpen their pencils. Rather, suppliers whose level of complexity is low to medium provide the most opportunity for auctions to outperform negotiations.
Bajari and colleagues also argue that the more complex the project, the more the buying firm may need input from potential contractors. They further suggest that negotiations are much more conducive than auctions to getting advice from suppliers and building partnerships with them. In addition, they find that negotiated contracts are more likely to go to highly reputable contractors, while auctions tend to benefit lower-quality contractors. Auctions focus exclusively on price, which makes lower-quality providers competitive. In fact, bidding for a contract in an auction may signal to the seller that you do not care about quality.
Finally, the researchers note that the attractiveness of auctions depends on the state of the economy. When times are hard, contractors will spend the time and effort required to place a bid. But when the economy is strong, contractors devote their time to billable work, and the number of bidders in auctions falls.