When to Deploy Test Auctions in Sourcing

We investigate when a buyer seeking to procure multiple units of an input may find it advantageous to run a “test auction” in which she has incumbent suppliers bid on a portion of the desired units. The test auction reveals incumbent supplier cost information that helps the buyer determine how many entrants (if any) to recruit at a cost prior to awarding the remaining units. The optimal number of entrant suppliers to recruit follows a threshold policy that is monotonic in the test auction’s clearing price unless the underlying supplier cost distribution is not regular. When setting her reserve price in the test auction, the buyer uses supplier recruitment as her “outside option”: if the reserve price is not met in the test auction, the buyer recruits new suppliers and runs a second auction. We compare the attractiveness of the test auction procedure relative to the more conventional procedure in which the buyer auctions off her entire demand in one auction. Since the buyer can choose ex ante which procedure to use, we propose using whichever has lower ex ante total (purchase plus recruitment) cost. Finally, using an optimal mechanism analysis, we find a lower bound on the buyer’s cost, and use that cost as a benchmark to show that our proposed sourcing strategy performs well given its ease of implementation.

The online appendix is available at https://doi.org/10.1287/msom.2017.0636.