BIDDING FOR CONTESTS

The procurement of product development and production services brings special strategic considerations to the buyer-seller relationship in i ndustrial and institutional markets. Multiple sourcing, in particular dual sourcing, is a likely way of dealing with the increased risks fac ed by buyers. However, there is lack of dual sourcing models that anal yze the selection and control process in an integrated fashion. This o mission has led to apparently contradictory findings in agency and auc tion theory. The paper models the strategic issues for a cost containm ent contest between two suppliers. The suppliers are drawn from severa l vendors who participate in a bidding competition. The supplier with the lower final cost in the contest wins a larger share of the pooled profit fee. Propositions are derived for the optimal cost-plus contest , and comparisons are made with the common incentive contract for the integrated selection and control model. The larger the winner's share, the greater the effort. The buyer can make a credible commitment to t he optimal winner's share. As the winner's share rises, however, the b id prices increase due to increased contract risk. This incentive-risk tradeoff determines (a) the optimal winner's share that minimizes exp ected procurement price, (b) the corresponding profit fee bid by suppl iers, (c) the ensuing cost control effort, and (d) the final price for the procurement. Comparisons with the common incentive contract tell us when the cost-plus contest induces more effort, and when bidding fo r a contest results in a lower final procurement price.