Should the buyer of a customized good use competitive bidding or negotiation to select a contractor? To shed light on this question, we offer a framework that first describes the buyer's choice of contracts, and then links this choice to the selection of competitive tendering or negotiations. The analysis suggests a number of possible limitations to the use of competitive tendering. These may perform poorly when projects are complex, contractual design is incomplete and there are few available

more »

... idders. Furthermore, competitive tendering may stifle communication between buyers and sellers, preventing the buyer from utilizing the contractor's expertise when designing the project. Implications of these results for procurement in the private and public sector are discussed. * This is a preliminary version of a future chapter to appear in Dimitri, Piga, and Spagnolo (Eds.) "Handbook of Procurement", forthcoming in Manufactured goods, such as computers, TVs and automobiles are mass produced, have standardized characteristics and are typically purchased at list price. Other goods, such as new buildings, fighter jets, custom software or consulting services are tailored to fit a procurer's specific and often unique needs. To procure these customized goods, the procurer hires a contractor who supplies the good according to a set of desired specifications. We call this the procurement problem. The procurement problem has attracted much attention both in policy and in academic circles. The main focus of academic economists has been on procurement by the public sector, in part because of its sheer importance to the economy. 1 For example, procurement by federal, state and local government accounts for more than 10 percent of Gross Domestic Product in the United States. Many private sector transactions are also governed by procurement contracts. Prominent examples include electronics components, custom software, automobile production, and building construction. When considering the procurement of goods and services, the procurer is faced with many challenges. First, she has to choose what exactly should be procured, and how to transmit her needs to the potential suppliers. Second, a contract must be laid out that includes contractual obligations and methods of compensation. Third, the procurer needs to decide how to award the procurement contract between the potential suppliers. Finally, the award mechanism should result in the selection of a qualified and desirable supplier and in the implementation of a cost-effective final product. Following up on these last two points, competitive tendering is widely recognized as an attractive procurement mechanism and is commonly advocated for several reasons. 2 Most notably it is viewed as a procedure that stimulates and promotes competition. By its nature, open competitive tendering invites potential suppliers from many venues. Furthermore, in the face of competition from many potential suppliers each one has strong incentives not to inflate his price. Indeed, fair market price discovery is often touted as a beneficial result of such tendering. Open competitive mechanisms are also known for their transparency, making it easier to prevent corruption both in the public and private sectors where procurement managers may have incentives to rig the system 1 See also Chapter 1 AND 3 for more facts on procurement in practice. 2 There has been a flurry of managerial and policy advice on using "reverse auctions" or "online reverse auctions" as these are referred to when online platforms are used. A search on the web of "reverse auction" will offer too many sites to mention.