Publication: RAND Journal of Economics
Publication Date: 22-JUN-07
Delivery: Immediate Online Access
Author: Gal-Or, Esther ; Gal-Or, Mordechai ; Dukes, Anthony

Article Excerpt
A buyer procuring a single input possesses private information about each potential supplier's degree of fit with the buyer's needs. She can search among suppliers either sequentially or simultaneously. As long as the distribution of the fit parameter is not overly skewed to the left, sharing information with suppliers yields intensified price competition under simultaneous search. Moreover, the buyer cannot benefit by providing suppliers additional information beyond their own fitness parameter. Information revelation is never optimal with sequential search.

1. Introduction

* Consider a small industrial buyer who wishes to procure a crucial input. If certain attributes, such as workmanship or style, are not fully specifiable and heterogeneous among potential suppliers, the buyer faces the problem of finding the supplier who offers her the best value. Because suppliers are differentiated, this value depends on both the extent of fit of the supplier and the price he charges. The buyer incurs a certain inspection cost in order to evaluate the extent of fit of each supplier. She is too small to be able to fully impose a mechanism that specifies the form of competition among the suppliers. However, the buyer does have some limited commitment power that permits her to precommit to a choice between simultaneous and sequential search. In the former case, she samples and inspects a certain set of suppliers simultaneously, by soliciting bids from them in the form of a request for quotes (RFQ). In the latter case, she approaches suppliers sequentially and, after each inspected supplier, she decides whether to accept his offer or continue her search. Which option is best for the buyer depends on a variety of factors, several of which we explore in this research.

One factor that is particularly important and is our focus in this article is the degree to which suppliers have information regarding how well their product fits with the needs of the buyer. On the one hand, a supplier who knows he is a good fit with the buyer's needs can charge a premium for his advantage, leaving the buyer with little remaining surplus. On the other hand, when a supplier knows he is a low fit, he may lower his price in order to remain competitive. This can induce lower prices overall if other suppliers know that low-fitting types are still in the bidding. As we show in this article, the extent to which information revelation benefits or harms the buyer depends on the procurement method she chooses. Specifically, we illustrate that, if the buyer chooses simultaneous search, she benefits if each supplier is informed of his goodness of fit. In contrast, with sequential search, the buyer benefits from withholding information from suppliers.

To see the intuition behind this distinction, note that, in sequential search, each supplier makes his offer unilaterally as opposed to the RFQ, in which supplier offers are made multilaterally. Consider a supplier in the former who knows his type and therefore his exact worth to the buyer. If each supplier, upon being contacted by the buyer, sets the price to extract the buyer's entire surplus, then the buyer has no incentive to continue her search in equilibrium. Furthermore, because each supplier faces the buyer only if contacted, there is no incentive on the part of the suppliers to undercut with price. Hence, it is necessarily suboptimal for the buyer to reveal information in a sequential search. Such revelation simply transfers informational rents from the buyer to the supplier. In contrast, information revelation with simultaneous search introduces two counteracting effects on the profits of the buyer. In addition to the transfer of informational rents from the buyer to each supplier that is still disadvantageous to the buyer, information revelation introduces also a positive effect in the form of intensified price competition. By revealing information with simultaneous search, low-fitness suppliers can remain competitive with highfitness suppliers by adjusting their bids downward. High-fitness suppliers who know their types as well as the fact that their competitors are also informed can anticipate intensified competition from lower fitness suppliers, which forces them to compete more aggressively as well.

We demonstrate that when the density function that characterizes the distribution of the fitness parameter in the population is nondecreasing, the positive intensified competition effect more than outweighs the negative rent transfer effect. As a result, the buyer benefits when each supplier knows his goodness of fit. We also show that the buyer cannot further increase his profits by informing each supplier not only of his own fit but that of all of his competitors in the bidding. This result implies, in particular, that the buyer need not establish an elaborate network of communication with suppliers that facilitates transmitting information about competitors. Instead, it is sufficient that the buyer provides a clear and detailed description of the specifications of the input she wishes to procure as well as the criteria she plans to utilize in evaluating the goodness of fit of suppliers. Providing such a detailed description of her preferences should facilitate each supplier to infer his own goodness of fit while remaining ignorant of the fit of his competitors. In spite of that, our analysis shows that suppliers compete as aggressively as they would if they knew the extent of fit of all the competing suppliers.

Because the buyer in our model does not have the bargaining power to fully extract the surplus of the suppliers (by posting a take-it-or-leave-it price, for instance), her expected payoff falls short of the payoff she could have obtained with unlimited precommitment capabilities. We show that the reduction in expected payoff due to limited precommitment power (i.e., only a choice between simultaneous and sequential search) is proportional to the difference between the expected values of the first- and second-order statistics of the fitness parameter in the sample of suppliers inspected by the buyer.

To illustrate the setting of this paper, consider a tire manufacturer who uses steel wires in the production process. The wires have to be cleaned from drawing lubricants using water. Large quantities of water are consumed in the cleaning process, implying that reusing the water may save production costs. The manufacturer seeks to procure filtering units to implement the cleaning process. There are different options open to her. She can use paper filter, vacuum filter with precoated drum, dissolved air floatation (DAF), filter press, and combinations thereof. Filters differ in their material cost, energy usage, cost of maintenance, and cleaning effectiveness. The manufacturer is the only one who knows the make-up of the filter unit she prefers best. The potential suppliers can obtain this information only if the manufacturer chooses to reveal her preferences. In order to fully evaluate the benefit from contracting with a potential supplier, the tire manufacturer must individually contact each supplier, obtain a quote, and determine the supplier's fit with respect to the different attributes she values. This, however, is costly because the manufacturer has to invest in some inspection process. Because suppliers are differentiated in this way, the manufacturer selects the supplier on other criteria in addition to quoted price. Our modeling framework permits buyers, therefore, to choose a supplier on the criterion of total value net of price.

The manufacturer can either approach suppliers one by one and evaluate each fit and price sequentially or, alternatively, she can approach a number of suppliers and request simultaneous quotes. In the latter case, she also inspects the goodness of fit of all of the sampled suppliers simultaneously. The manufacturer must also decide whether to reveal information to each potential supplier about his degree of fit with the buyer's requirements. Given that some of those requirements can be subjective, the extent of fit of a given supplier is private information that can only be observed by the manufacturer herself, unless she chooses to clearly communicate to suppliers the criteria she utilizes in evaluating the filtering units.

Others have recognized that there exist strategic considerations in a buyer's choice of procurement process. At a fundamental level, the early works in search have established that sequential search is preferable over simultaneous search when the distribution of prices is exogenous (DeGroot, 1970; Morgan and Manning, 1985). In our model, price setting by the sellers is endogenous and depends on the buyer's procurement method. In particular, we demonstrate that, by soliciting simultaneous bids from suppliers, the buyer may induce more aggressive pricing than when searching sequentially. This last result is related to the one obtained in Daughety (1992) and Daughety and Reinganum (1991, 1992), where consumers search sequentially but may choose to obtain two quotes simultaneously in order to enhance their bargaining power. Another paper that is related to the present research is that of Wolinsky (2005), who also considers a buyer with limited commitment power. In his model, though, the buyer has even weaker powers than in our setting in that she can only conduct sequential search among suppliers. This search method results in significant inefficiencies in his model, mainly because suppliers have to make preliminary unobservable efforts. Sequential search yields suboptimally low levels of effort at the equilibrium. In our model, suppliers are differentiated, as they are in Wolinsky (2005), but they do not make any effort investments to improve their inputs.

Another strand of literature that is related to the present analysis is the literature on information sharing in oligopoly. This literature has demonstrated that competing firms may be worse off if they share information about uncertain states of the world affecting their environment (see, for instance, Clarke, 1983; Crawford and Sobel, 1982; Gal-Or, 1985b, 1986; Shapiro, 1986; Vives, 1984). In contrast with the present paper, buyers are completely powerless in this previous literature. As well, while sharing information may reduce the expected profits of each seller, it does not affect the average price level facing the consumers. In our setting, the buyer conducts an auction to procure the input. When she actively shares information with the sellers, she forces them to compete more aggressively, thus reducing the overall level of prices facing her.

The RFQ process we model is related to the general theory of auctions and competitive bidding, which has been extensively...



NOTE: All illustrations and photos have been removed from this article.



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