Mechanism Design in Project Procurement Auctions with Cost Uncertainty and Failure Risk

Abstract

Project procurement has two important attributes: cost uncertainty and failure risk. Due to the incomplete feature of such attributes, a novel mechanism incorporating contingent payments and cost sharing contracts is proposed for the buyer. Constructing models of bid decisions for risk averse and risk neutral suppliers, respectively, closed-form solutions of optimal bid prices are derived. By investigating the properties of bid prices in a first-score sealed-bid reverse auction, we find that when the degree of risk aversion or the variance of unpredictable cost is sufficiently small, bid prices of risk averse suppliers could be lower than those of risk neutral suppliers. Yet risk averse suppliers always bid higher than risk neutral suppliers in a second-score sealed-bid reverse auction. An interesting result verified by numerical experiments is that the classical revenue equivalence theorem no longer holds for the proposed mechanism if suppliers involve risk averse behavior. In this case, the buyer's best choice is to adopt a first-score sealed-bid reverse auction. We also provide decision support for the buyer to achieve optimal expected profit.