Scaling Auctions as Insurance: A Case Study in Infrastructure Procurement

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Abstract:

The U.S. government spends about 1% of GDP (165B USD) each year on highway and bridge investment, often employing scaling auctions to procure construction work from private firms. Bidders in a scaling auction submit unit price bids for each piece of material required to complete a project. The winner is determined by the lowest total cost given government estimates of the amount of each material needed, but paid based on the amount used. This creates incentives to skew bids (placing high unit bids on items bidders expect to exceed the government's quantity expectations and low bids on others), and raises concerns of rent-extraction among policymakers. If bidders are risk averse, however, scaling auctions provide a distinctive way to generate surplus: they enable bidders to limit their risk exposure by placing low unit bids on items with greater uncertainty. To assess this effect empirically, we develop a structural model of scaling auctions with risk averse bidders. Using data on bridge maintenance projects undertaken by the Massachusetts Department of Transportation (MassDOT), we demonstrate reduced form evidence that bidding behavior is consistent with optimal skewing under risk aversion. We then estimate bidders' risk aversion, the risk in each auction, and the distribution of bidders’ private costs. Finally, we simulate equilibrium item-level bids under counterfactual settings to estimate the fraction of MassDOT spending that is due to risk and evaluate alternative mechanisms under consideration by MassDOT. We find that scaling auctions provide substantial savings to MassDOT relative to lump sum auctions and suggest several policies that might improve on the status quo.

Last updated on 03/03/2019