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CeDEx 2016-03: Dual Sourcing with Price Discovery

Dual Sourcing with Price Discovery

Summary

It is uncontroversial that procurement procedures should minimize costs. In some procurement markets, however, it is not only important to minimize procurement costs but also to avoid dependence on a single provider. Having only one supplier risks that the buyer is 'locked in' with one provider and experiences shortage in the case that this supplier cannot fulfil his obligations. Currently, for example, the state of Texas buys influenza vaccines from Novartis and Sanofi Pasteur, while meningococcal vaccines are provided by Sanofi Pasteur and Glaxosmithkline. Similarly, in the private sector, Nokia and Toyota follow a dual sourcing strategy in order to reduce supply chain risk. Since having several providers might require to forgo economies of scale or to buy from providers with different efficiency levels, conventional wisdom holds that there is a trade-off between expenditure minimization and a dual (or even multiple) sourcing strategy.

In this Nottingham School of Economics working paper, José Alcalde and Matthias Dahm propose a procurement procedure that results in dual sourcing but has the potential to avoid this trade-off. Shares are allocated endogenously, depending on the suppliers' bids. The procedure obtains dual sourcing by assigning positive shares to the two most competitive bids and uses discarded bids to endogeneize the reserve price. In equilibrium the two most competitive suppliers are awarded contracts. Surprisingly, when discarded suppliers are competitive enough, the procedure not only allows taking advantage of dual sourcing but also generates lower procurement expenditures than a standard auction for sole sourcing. The authors also show that providers reveal their costs truthfully and that the procurement procedure can be used under different assumptions of what providers know about each others' costs, provided the assumption of private values holds.

CeDEx Discussion Paper 2016-03, Dual Sourcing with Price Discovery by José Alcalde and Matthias Dahm

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Authors

José Alcalde and Matthias Dahm

 

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Posted on Wednesday 9th March 2016

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