Optimal Procurement Design in the Presence of Supply Risk

Abstract

This paper analyzes optimal auction design when delivery of supply is uncertain. We consider a buyer facing multiple potential suppliers, each having an associated (exogenous) reliability that quantifies its risk of supply failure. We design optimal mechanisms that depend on the buyer's level of information regarding the suppliers' cost of production and reliability. When supplier reliability is known, we find that the optimal allocation resembles the allocation under full information, but with inflated production costs. When it is unknown, the same result is true when cost and reliability of a supplier are independent. Furthermore, the buyer does not have to pay any rent for information on suppliers' reliability. Moreover, we assess the benefits of the optimal mechanism compared to traditional auctions that ignore supply risk.