Using Cost Modeling to Set a More Informed Procurement Auction Reserve Price

Reserve prices are commonly used in procurement auctions, and the logic is simple: They help the buyer avoid paying too much for the contract. The reserve price is set by the buyer before the auction based on the buyer’s knowledge about suppliers’ costs. In practice, buyers can refine their knowledge about suppliers’ costs through activities known in industry as cost modeling. In this paper we explore the value of such activities to help the buyer set a more informed reserve price prior to an auction. Specifically, we analyze which supplier(s) to learn about, which portion(s) of the costs to learn, the value of increasing the number of suppliers learned about, and the depth to which the buyer should learn about each supplier. Our analysis accommodates a rich set of supply base characteristics, such as ex ante asymmetric suppliers, supplier cost correlations, and possible collusion between suppliers. Interestingly, learning about the supplier whose cost is the most uncertain is not necessarily optimal, nor is learning about the cost portion that contributes most to the total cost. We also show that conventional intuition that the value of additional information has a diminishing rate of return does not apply. Finally, we compare the benefit of inviting additional suppliers versus setting a more informed reserve price and find that the latter can outweigh the former, which is in stark contrast with received wisdom from past work (e.g., the classic paper Bulow and Klemperer (1996)) that ignored the possibility of cost modeling.