Testing Vickery’s Revenue Equivalence Theory in Construction Auctions

Vickery, “second-price,” auctions are often used because of their characteristic of producing truthfulness within bidders. The inherent truth telling creates an auction which, in the long run, operates under true valuations, and procures socially optimum prices. However, the idealness Vickery auctions hold seems to sometimes dissolve when more unique attributes are applied to the auction.

In the construction industry, the form of auctions slightly differ from more common auctions. For instance, there is only one job (the buyer) for multiple contractors (the sellers). This mismatch places the auction, interestingly, onto the sellers rather than the buyers, meaning the sellers must compete with each other over how much compensation they are to receive for their work. Obviously, the buyer is looking to complete the job with the least expensives, meaning he is looking for the contractor with the lowest asking price. The final twist is that the auction is run over multiple rounds, allowing others to see the bids of others after each round, and readjuest their bidding strategy for the next. The most common practice in the industry is to use sealed first-price (”lowest-price” ) auctions to determine which contractor receives the job and for what price he will work for. Though commonly thought to produce relatively accurate valuations and prices for the contractors, Drew and Skitmore deemed there was cause for untruthfulness and uncertainty in bidding, leading them to wonder if a Vickery second-price auction would produce more socially beneficial results. They figured that in a first-price auction, prices were being driven up for the buyers because the contractors all would be reluctant of bidding their true value, and instead upping the bid to safeguard themselves from not making enough profit.

The best strategy in a first price sealed low bid auction (where the bidder submitting the lowest bid wins the contract at the value of the lowest bid) is for contractors to
1. assume theirs is the lowest bid;
2. determine their bid; and then
3. adjust the bid upwards to the second lowest bid. However, for construction contract auctions, the “compactness” of the bids makes it virtually impossible to estimate the value of the second lowest bid with sufficient accuracy, and the problem facing contractors is that increasing their bid too little results in lost revenue to the contractor while increasing too much means losing the competition.

The hypothesis of the paper was that instituting a second-price auction would produce similar profit margins for the contractors while maintaining similar costs for the clients, though producing some external benefits as well:

[The revenue equivalence theory] implies that construction clients and contractors would be no worse off financially, irrespective of whether a FPA or SPA is used. There is likely to be a psychological difference, however, with contractors feeling they are getting a better deal. One outcome of this could be that contractors will be happier with their lot and less inclined to seek ways of extracting more money out of clients by cutting corners and/or claiming extras. In other words, a less disputatious industry may result—solving, at a stroke, what has been recognized over the years as the biggest problem facing the construction industry worldwide

They proceded to run a simulation which charted the differences in first and second price auctions for varying types of contracting jobs. Under the circumstances of these contracting auctions, the attributes were effectively complete reverses of the normal type of Vickery auction: it was the sellers, not the buyers, who were bidding on the price of the job, and instead of awarding the “item” to the highest bidder at the second highest price, the lowest bidder gets the construction job and does it at the second lowest price.

Would these characteristics significantly alter the normal idealness and practicality of second-price auctions, or would it produce the same optimizing outcomes? After a robust simulation and thorough statistical analysis, it turned out that buyers would actually be forced to pay more for the job (i.e. the lowest bids of the contractors went up, effectively raising the final price of the job). The attributes of this type of auction caused slight upward change in bidding, but then effectively raised the price more by allocating it to the second lowest.

In class, we have recently been discussing the strategies behind keyword-based advertising, and though we have examined many methods to generating income, it has been concluded that even Google and other search engines do not know the optimal strategy that produces the highest profits. This example shows how changing the attributes of an auction can cause it to slightly, or in this case significantly, deviate from its normal economic equilibrium properties. Examples such as this should highlight to Google that since they are dealing with a new and unusual form of advertising, that tweaking their ranking and bidding systems by altering their characteristics might, in fact, be beneficial for them to play around with, and doing so might produce much better profit margins for the company than they currently have.