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Rational under-pricing in bidding strategy: a real options model

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  • C. Y. Yiu
  • C. S. Tam
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    Abstract

    Under-pricing in construction tenders is a common phenomenon and is commonly explained by the need of cash flows and penetration strategy. However, these explanations involve profit cutting and therefore are not plausible in explaining a long-term persistent phenomenon of under-pricing. A real options model is proposed and using the binomial lattice method a real-life construction project tender was analysed to examine how management flexibility and uncertainty provide real options value. When uncertainties of cost items in a tender exist and choices are available to defer and switch modes of construction, then a valuable option is available to the bidders. It amounts to about 4% of the lump sum tendered in our case. The under-priced portion is the options value which the bidder is willing to pay for the flexibility and the uncertainty. These findings enable contractors to be more competitive and to estimate construction costs more accurately in devising their bid strategies.

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/01446190600601560
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    Bibliographic Info

    Article provided by Taylor & Francis Journals in its journal Construction Management and Economics.

    Volume (Year): 24 (2006)
    Issue (Month): 5 ()
    Pages: 475-484

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    Handle: RePEc:taf:conmgt:v:24:y:2006:i:5:p:475-484

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    Web page: http://www.tandfonline.com/RCME20

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    Web: http://www.tandfonline.com/pricing/journal/RCME20

    Related research

    Keywords: Real options; pricing; bidding strategy; tendering;

    References

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    1. C. Perry & I. D. Greig, 1975. "Estimating the Mean and Variance of Subjective Distributions in PERT and Decision Analysis," Management Science, INFORMS, vol. 21(12), pages 1477-1480, August.
    2. Kim, In-Gyu, 1998. "A model of selective tendering: Does bidding competition deter opportunism by contractors?," The Quarterly Review of Economics and Finance, Elsevier, vol. 38(4), pages 907-925.
    3. Michael Garvin & Charles Cheah, 2004. "Valuation techniques for infrastructure investment decisions," Construction Management and Economics, Taylor & Francis Journals, vol. 22(4), pages 373-383.
    4. Gjolberg, Ole & Guttormsen, Atle G., 2002. "Real options in the forest: what if prices are mean-reverting?," Forest Policy and Economics, Elsevier, vol. 4(1), pages 13-20, May.
    5. Jean Tirole, 1985. "Procurement and Renegotiation," Working papers 362, Massachusetts Institute of Technology (MIT), Department of Economics.
    6. Tien Foo Sing, 2002. "Time to build options in construction processes," Construction Management and Economics, Taylor & Francis Journals, vol. 20(2), pages 119-130.
    7. Kwong Wing Chau, 1997. "Monte Carlo simulation of construction costs using subjective data: response," Construction Management and Economics, Taylor & Francis Journals, vol. 15(1), pages 109-115.
    8. Sarkar, Sudipto, 2003. "The effect of mean reversion on investment under uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 28(2), pages 377-396, November.
    9. Krishna Mochtar & David Arditi, 2001. "Pricing strategy in the US construction industry," Construction Management and Economics, Taylor & Francis Journals, vol. 19(4), pages 405-415.
    10. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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    Cited by:
    1. Chiara D’Alpaos & Michele Moretto & Paola Valbonesi & Sergio Vergalli, 2012. "Time Overruns as Opportunistic Behavior in Public Procurement," Working Papers 2012.78, Fondazione Eni Enrico Mattei.
    2. João Adelino Ribeiro & Paulo Jorge Pereira & Elísio Brandão, 2013. "Volume Uncertainty in Construction Projects: a Real Options Approach," CEF.UP Working Papers 1309, Universidade do Porto, Faculdade de Economia do Porto.

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