When Does It Pay to Delay Supplier Qualification? Theory and Experiments

We study a procurement setting in which the buyer seeks a low price but will not allocate the contract to a supplier who has not passed qualification screening. Qualification screening is costly for the buyer, involving product tests, site visits, and interviews. In addition to a qualified incumbent supplier, the buyer has an entrant of unknown qualification. The buyer wishes to run a price-only, open-descending reverse auction between the incumbent and the entrant, and faces a strategic choice about whether to perform qualification screening on the entrant before or after the auction. We analytically study the buyer's optimal strategy, accounting for the fact that under postauction qualification, the incumbent knows he could lose the auction but still win the contract. In our analysis, we derive the incumbent's optimal bidding strategy under postauction qualification and find that he follows a threshold structure in which high-cost incumbents hold back on bidding--or even boycott the auction--to preserve their profit margin, and only lower-cost incumbents bid to win. These results are strikingly different from the usual open-descending auction analysis where all bidders are fully qualified and bidding to win is always a dominant strategy. We test our analytical results in the laboratory, with human subjects. We find that qualitatively our theoretical predictions hold up quite well, although incumbent suppliers bid somewhat more aggressively than the theory predicts, making buyers more inclined to use postauction qualification. <i>This paper was accepted by Martin Lariviere, operations management.</i>