Sourcing through Auctions and Audits

Buyers often find that obtaining complete information about suppliers is costly. In such scenarios, there is a trade-off between the costs of obtaining information and the benefits that accrue to the owners of such information. There are also various ways in which the missing information can be obtained or inferred. In this paper, we compare the efficiency of obtaining information via the classical mechanism design approach, which relies on the information available before the contracts are designed, with that of an “audit-based” approach, which relies on the information obtained after the fact. In our model, a single buyer (the Stackelberg leader) wishes to procure a package of products or services from various competing suppliers that possess private cost information. We allow for arbitrary cost and revenue functions, and can incorporate multiple cost and revenue drivers. We show how the buyer can optimize her profit and at the same time coordinate the channel by using a contract scheme that involves auctions, audits, and profitsharing. We also examine the behavior of this mechanism when the supplier can exert effort to reduce cost but the cost of effort cannot be verified. We propose several mechanisms for different pre-contract informational scenarios and compare their performance with the mechanisms in Dasgupta and Spulber (1990) and Chen (2001).