Rational under-pricing in bidding strategy: a real options model
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.
Volume (Year): 24 (2006)
Issue (Month): 5 ()
|Contact details of provider:|| Web page: http://www.tandfonline.com/RCME20|
|Order Information:||Web: http://www.tandfonline.com/pricing/journal/RCME20|
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- 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.
- 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.
- Jean Tirole, 1985.
"Procurement and Renegotiation,"
362, Massachusetts Institute of Technology (MIT), Department of Economics.
- Tien Foo Sing, 2002. "Time to build options in construction processes," Construction Management and Economics, Taylor & Francis Journals, vol. 20(2), pages 119-130.
- 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.
- 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.
- 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.
- 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.
- Michael Garvin & Charles Cheah, 2004. "Valuation techniques for infrastructure investment decisions," Construction Management and Economics, Taylor & Francis Journals, vol. 22(4), pages 373-383.
- 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.
When requesting a correction, please mention this item's handle: RePEc:taf:conmgt:v:24:y:2006:i:5:p:475-484. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Michael McNulty)
If references are entirely missing, you can add them using this form.