Procurement Auctions and Eroding Price
Contracts
in the
Presence of Learning by Doing
Wedad Elmaghraby
ISyE,
Georgia Institute of Technology
One
procurement method that creates competition among suppliers and is gaining
popularity is auctions. Auctions allow suppliers to compete on cost (in
addition to other possibly verifiable and observable attributes) and have been
shown to lower procurement costs in a wide range of settings. While short-term
auctions are a suitable procurement mechanism if a buyer is purchasing a
commodity product or making a one-time purchase from a competitive supplier
base, their performance in a repeat purchase setting for non-commodity products
is less clear. In particular, if a supplier experiences “learning by doing”,
causing his production costs to decrease over time, or if there are costs
associated with switching suppliers, then the appropriateness of simple
short-term auctions may be called into question. One procurement method that is
employed in the electronics industry in the presence of learning by doing is an
erosion rate policy. Under an erosion rate policy, the buyer initially
competitively awards production to the least cost supplier via an auction.
Before the auction takes place, the buyer makes it clear to the suppliers that,
if chosen, a sequence of price reductions will be mandatory in subsequent
periods, with the price reductions defined upfront. In the event that a
supplier, once chosen, is unable to deliver at the agreed upon reduced prices,
then the buyer acts upon her threat and is forced to turn to an alternative
supplier. In this paper, we study the design of the optimal Erosion Rate
policy. We characterize the optimal discount price schedule as a function of
the market structure. We go on to compare the performance of an Erosion Rate
policy against two base cases : (1) the buyer holds an
(independent, short-term) auction in each period and (2) the buyer procures all
of her demand in a single ‘bundle’ auction.