Auctioning Supply Contracts

This paper studies a procurement problem with one buyer and multiple potential suppliers who hold private information about their own production costs. Both the purchase quantity and the price need to be determined. An optimal procurement strategy for the buyer requires the buyer to first design a supply contract that specifies a payment for each possible purchase quantity and then invites the suppliers to bid for this contract. The auction can be conducted in many formats such as the English auction, the Dutch auction, the first-priced, sealed-bid auction, and the Vickrey auction. The winner is the supplier with the highest bid, and is given the decision right for the quantity produced and delivered. Applying this theory to a newsvendor model with supply-side competition, this paper establishes a connection between the above optimal procurement strategy and a common practice in the retail industry, namely, the use of slotting allowances and vendor-managed inventory. Also discussed in the newsvendor context are the role of well-known supply contracts such as returns contracts and revenue-sharing contracts in procurement auctions, the scenarios where the buyer and suppliers may possess asymmetric information about the demand distribution, and how the cost of supply-demand mismatch is affected by supply-side competition. Finally, this paper compares the optimal procurement strategy with a simpler but suboptimal strategy where the buyer first determines a purchase quantity and then seeks the lowest-cost supplier for the quantity in an auction.