Procurement with Unforeseen Contingencies by Herweg and Schmidt

 Today's post is on Procurement with Unforeseen Contingencies by Fabian Herweg and Klaus Schmidt, which was published last year in Management Science. This is about buyers who want to procure complex goods, whose designs they have made themselves. In price-only auctions, the seller/contractor who will make the product based on the design has no incentive to share his expertise, which would minimize design adjustment costs. The authors propose a mechanism that both "allocates the contract to the seller with the lowest cost and that induces all potential sellers to reveal any information that they may have about possible design flaws early (i.e., before the contract is assigned)." The authors' approach takes into account that, although the buyer knows the potential design may be flawed, he has "no idea what possible flaws look like and what their payoff implications are." 

The authors explain their mechanism as follows: sellers have to point out any design few they discovered to an independent arbitrator, who verifies the flaws, estimates their payoff consequences and assigns payments to the sellers as follows: "if a seller is the only one who reported a flaw, he will get a reward that is equal to the additional profit he cud have made if he had kept the information to himself, won the contract, and renegotiated with the buyer; otherwise, he gets nothing." Then "the revealed flaws are fixed and the improved design is allocated to the seller with the lowest cost in a sample Vickrey auction."  

A key contribution of the paper to the literature, besides the novel mechanism, is that it contributes to the literature on "robust implementation" (which is why it caught my attention), which requires mechanisms not to depend on unobservable beliefs and higher-oder beliefs of the participants. In addition, the authors' mechanism "does not require the mechanism designer to know all possible states of the world (i.e., the set of possible flaws and their payoff consequences)"; instead, it combines ex post incentive compatibility and ex post verifiability.