Procurement with specialized firms

This paper analyzes optimal procurement mechanisms in a setting typical for postliberalization industries. The procurement agency has incomplete information concerning the firms’ cost functions and cares about quality as well as price. Low type firms are cheaper than high type firms in providing low quality but more expensive when providing high quality. Hence, each type is specialized in a certain quality level. We show that this specialization leads to a bunching of types on profits, i.e. a range of firms with different cost functions receives zero profits and therefore no informational rents. If first best welfare is monotone in the efficiency parameter, the optimal mechanism can be implemented by a simple auction. If first best welfare is U-shaped in type, the optimal mechanism is not efficient in the sense that types providing a lower second best welfare win against types providing a higher second best welfare. JEL codes: D82, H75, L51 keywords: procurement, specialization, participation constraint Boone: Department of Economics, University of Tilburg, P.O. Box 90153, 5000 LE, Tilburg, The Netherlands; Tilec, CentER and CEPR. Schottmüller: Department of Economics, Tilec and CentER, Tilburg University. We gratefully acknowledge financial support from the Dutch National Science Foundation (VICI 453.07.003).