When the Highest Bidder Loses the Auction: Theory and Evidence from Public Procurement

When bids do not represent binding commitments, the use of a …rst price sealed bid auction favors those bidders who are less penalized from reneging on their bids. These bidders are the most likely to win but also the most likely to default on their bid. In this paper I study theoretically two methods often used in public procurement to deal with this problem: (1) augmenting the …rst price auction with an ex-post veri…cation of the responsiveness of the bids and (2) using an average bid auction in which the winner is the bidder whose bid is closest to the simple average of all the bids. The average bid auction is new to economics but has been proposed in civil engineering literature. I show that when penalties for defaulting are asymmetric across bidders and when their valuations are characterized by a predominant common component, the average bid auction is preferred over the standard …rst price by an auctioneer when the costs due to the winner’s bankruptcy are high enough. Depending on the cost of the ex-post veri…cation, the average bid auction can be dominated by the …rst price with monitoring. I use a new dataset of Italian public procurement auctions, run alternately using a form of the average bid auction or the augmented …rst price, to structurally estimate the bids’veri…cation cost, the …rms’mark up and the ine¢ ciency generated by the average bid auctions. The estimation procedure proposed uses the informational content of the reserve price to account for unobserved heterogeneity in auctions. JEL: DL22, L74, D44, D82, H57. PhD Candidate at the University of Chicago, Department of Economics. E-mail address: [email protected]. I would like to thank Ali Hortacsu, Roger Myerson, Philip Reny and Timothy Conley for their guidance. I also bene…ted from conversations with Marianne Bertrand, Jeremy Fox, Gustavo Piga and Jesse Shapiro and from comments of the participants at the seminars at the University of Chicago and at the Bank of Italy and at the conferences of the IIOC in Washington, ES in Pittsburgh, EEA in Milan and EARIE in Toulouse where I presented preliminary versions of this research.