Precontractual Investment and Modes of Procurement

We study a repeated game in which a buyer must decide whether to procure goods whose design may turn out to be defective through auctions or negotiations. To reduce the likelihood of failure, the buyer must motivate the potential suppliers to make an investment before the contract is signed. As the noisy signal of the supplier’s investment is non-verifiable, the buyer can induce the suppliers to invest only through relational contracts, that is informal agreements sustained by the parties’ concern about the future. We find that auctions may not enable the buyer to implement a surplus-increasing relational contract even when the players are very patient. Therefore, negotiations may be adopted since they are more effective in stimulating the supplier’s investment. We also show how the possibility of inducing the supplier’s investment as well as the choice of the procurement mode affect the buyer’s initial specification of the good. Moreover, we find that relational contracting may be valuable even when a design failure can be verified by a court. Finally, we highlight how our model is able to reconcile several real-world procurement practices.