Auctions in defense acquisition: theory and experimental evidence - Research

Acquisition Review Quarterly, Summer, 2002 by Bruce G. Linster, David R. Mullin

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This article explores the implications of the theory and experimental evidence for auctions in the defense acquisition process. We begin with a brief review of the simplest auctions and proceed to recent theoretical/experimental results. The theoretical and experimental results discussed can shed light on efficient acquisition in the Department of Defense.

Auctions have been around for thousands of years. People buy and sell goods, services, and financial assets every day through auctions. More to the point, individuals and governments routinely use auctions to purchase goods and services from suppliers. Anyone wishing to see just what sorts of things are bought and sold by auction need only check one of the many online auction sites available today. When the Federal Acquisition Rules were rewritten in 1997 (Harris, 2001), the Office of Management and Budget eliminated the prohibition on auctions (Messmer, 2000). The enhanced technology currently available makes online auctions more appealing than ever, and the General Services Administration (GSA) has encouraged it's use.

The Department of Defense (DoD) has recently begun purchasing with online auctions -- receiving offers from suppliers for things ranging from computers to equipment for U.S. Navy vessels. The Navy was the first to try online auctions for procuring airplane and ship parts. The Army's first venture into auctions was to purchase IBM ThinkPads, saving 40 percent off the standard GSA price. Since then, the Army has bought spare parts for the Patriot Missile system. The Air Force first tested the online auction waters in August 2000 to acquire computer equipment and saved about $88,000, or 27 percent of the estimated cost.

Now that auctions are possible, even encouraged, for DoD acquisition, the question arises as to how these auctions should be conducted. The purpose of this essay is to discuss the different types of auctions DoD may employ and describe the characteristics and qualities associated with each. When buying a single item (or lot of items), like a certain quantity of computers as in the Army case, what are the properties of a sealed-offer auction relative to a reverse auction conducted online? After discussing the theoretical properties of these auctions, we will review some of the pertinent experimental literature that may have something to say about each type of auction. Finally, we will conclude with a summary of the significance of these results for DoD auctions.

THE THEORY

The most commonly studied auctions are the sealed-bid auction and the English auction. These auctions, along with the complementary auctions designed to purchase items, are described in Table 1. It is not immediately clear that any of these auctions has an advantage over the others. The theory of sealed-bid and English auctions is well developed elsewhere. (1) 'In this section we discuss the types of auctions most likely used in government acquisition, sealed-offer and reverse auctions, and draw inferences for these auctions from the substantial Literature for the complementary sealed-bid and English auctions.

A derivation of predictcd behavior in scaled-offer and reverse auctions under the assumption of risk-neutrality is provided in Appendix A. It is important to note that in both types of auctions with risk-neutral suppliers the expected price of the item sold to the government is the same, although the bidding strategies are clearly different. The intuitive result that the expected offer price decreases as the number of suppliers increases is also made concrete. It is clear that the two types of auctions are, in this very simple environment, equivalent in terms of expected outcomes although they do not have the same optimal bidding/offer strategies. This result is well known in the auction literature as the revenue-equivalence result, (2) which in the context of the auctions we are discussing might better be called an expenditure-equivalence result. Note, however, that this expenditure-equivalence depends heavily on the risk-neutrality assumption. It can be shown that, whereas risk aversion will not alter the r esults for the reverse auction, the sealed-offer auction will generate lower expected offer prices when suppliers are risk averse. (3)

Although the sealed-price and English auctions have been the most commonly analyzed, the isomorphism between these auctions and their complements, the sealed-offer and reverse auctions, allows us to make inferences from the auction literature and apply it for acquisition purposes. Also, economists have conducted many experiments to test the theoretical predictions of behavior in auctions. In the next section we describe some of the experimental economics literature on auctions and how it relates to the kind of government auctions that interest us here.

THE EXPERIMENTAL EVIDENCE

In general, the experimental evidence does not address sealed-offer or reverse auctions directly. However, the fact that the experimental evidence suggests that bidding behavior in English auctions is consistent with theoretical predictions strongly indicates equilibrium behavior among suppliers in reverse auctions. The results of experimental sealed-bid auctions are consistent with risk-averse buyers, however. Specifically, Cox, Roberson, and Smith (1982) and Coppinger, Smith, and Titus (1980) reported higher than expected bids in their sealed-bid auction experiments -- results consistent with risk-averse buyers. These results hold regardless of the number of bidders who participated. This leads us to expect risk-averse behavior among suppliers in the sealed-offer auctions and lower offer prices irrespective of the number of suppliers.