Procurement Mechanisms for Differentiated Products

Procurement Mechanisms for Differentiated Products

September 2015Working Paper No. 3450

We consider the problem faced by a procurement agency that runs an auction-type mechanism to construct an assortment of di↵erentiated products with posted prices, o↵ered by strategic suppliers. Heterogeneous consumers then buy their most preferred alternative from the assortment as needed. Framework agreements (FAs), widely used in the public sector, take this form; the central government runs the initial auction and then the public organizations (hospitals, schools, etc.) buy from the selected assortment. This type of mechanism is also relevant in other contexts, including private procurement settings and the design of drug formularies. When evaluating the bids, the procurement agency must consider the optimal trade-o↵ between o↵ering a richer menu of products for consumers versus o↵ering less variety, hoping to engage the suppliers in a more aggressive price competition. We develop a mechanism design approach to study this problem. We characterize the optimal mechanism, which typically restricts the entry of close-substitute products to the assortment to induce more price competition among suppliers, without much damage to variety. We then use the optimal mechanism as a benchmark to evaluate the performance of the Chilean government procurement agency’s current implementation of FAs, used to acquire US$2 billion worth of goods per year. Through a combination of theoretical and numerical results we show how the performance of such FAs can be considerably improved by introducing simple modifications to current practice which, similarly to the optimal mechanism, increase price competition among close substitutes.