When the Highest Bidder Loses the Auction: Theory and Evidence from Public Procurement

When bids do not represent binding commitments, the use of a first price sealed bid auction favors those bidders who are less penalized from reneging on their bids. These bidders are the most likely to win but also the most likely to default on their bid. In this paper I study theoretically two methods often used in public procurement to deal with this problem: (1) augmenting the first price auction with an ex-post verification of the responsiveness of the bids and (2) using an average bid auction in which the winner is the bidder whose bid is closest to the simple average of all the bids. The average bid auction is new to economics but has been proposed in the civil engineering literature. I show that when penalties for defaulting are asymmetric across bidders and when their valuations are characterized by a predominant common component, the average bid auction is preferred over the standard first price by an auctioneer whose costs due to the winner's bankruptcy are high enough. Depending on the cost of the ex-post verification, the average bid auction can be dominated by the first price with monitoring. I use a new dataset of Italian public procurement auctions, run alternately using a form of the average bid auction or the augmented first price, to structurally estimate the bids' verification cost, the firms' mark up and the inefficiency generated by the average bid auctions. The estimation procedure proposed uses the informational content of the reserve price to account for unobserved heterogeneity in auctions.