Procurement with Cost and Noncost Attributes: Cost-Sharing Mechanisms

A buyer faces a two-dimensional mechanism design problem for awarding a project to one among a set of contractors, each of whom is privately informed about the contractor’s cost and the contractor’s estimate of an a priori random noncost attribute. The winning contractor realizes the noncost attribute upon the project’s completion and may “manipulate” it in a costless manner (if such a manipulation is beneficial to the contractor). The noncost attribute inflicts a disutility cost on the buyer. This procurement problem arises in situations such as highway construction projects, in which completion times are a major concern. We establish the significance of incorporating the possibility of manipulation in two ways: (1) Using an optimal mechanism obtained by ignoring the possibility of manipulation can generate perverse incentives for the winning contractor to engage in manipulation. (2) The privacy of the noncost estimates can generate information rent only because of the possibility of contractors’ manipulation. We further study the family of cost-sharing mechanisms as a nonmanipulable, easy-to-implement, and near-optimal solution to the buyer’s procurement problem. In a cost-sharing mechanism, the winning contractor is selected via a second-price auction and needs to reimburse a prespecified fraction—referred to as the cost-sharing fraction—of the buyer’s disutility cost upon completion of the project. We show that the cost-sharing fraction plays an unequivocal role in capturing the essential trade-off between allocative inefficiency and information rent. We also characterize the optimal cost-sharing fraction and offer prescriptive guidelines on the choice of this fraction based on the second-moment information of the buyer’s belief distribution. Finally, we establish the theoretical performance guarantees for the optimal cost-sharing mechanism.