“Competitive tenders induce higher price mark-ups in renegotiations, eventually leading to higher overall prices” is a common concern raised against competitive negotiation designs, such as auctions.

Buyers fear that in a competitive setting, sellers offer low prices before the nomination in order to win the tender, but improve their profitability after nomination via aggressive price renegotiations. If true, this would create the perverse effect that auctions may induce low initial Procurement costs but ultimately result in higher overall costs.

Examples seem to confirm the concern

At first glance, well-known examples of large-scale public projects seem to confirm this concern, such as the Elbphilharmonie in Hamburg and the Sydney Opera House. Both projects have in common that they were awarded via a competitive tender and exceeded their initial budget several times over. Moreover, anecdotes in the private sector stress that sellers perceive a highly competitive Procurement process as unfair and will reciprocate by using their increased bargaining power after nomination to negotiate significant price increases via change management (Ryan, 2020).  Therefore, competitive negotiation designs may back-fire in two ways: higher long-run Procurement costs and a deterioration of supplier relationships.

Is it true though?

In this blog article, we challenge the intuitively appealing hypothesis that competitive tenders lead to tougher price renegotiations and therefore result in higher overall costs. Firstly, we argue that while industrial economic theory predicts that the possibility of renegotiations after an auction impacts initial price offers, neither the negotiation design nor competition intensity has a predicted effect on price mark-ups. Secondly, we reason that taking reciprocity and fairness concerns into account, there is no conclusive behavioural theory that predicts a competitive negotiation process will back-fire. Instead, a transparent and binding negotiation design may even foster fair offers and reciprocal behaviour.

In addition, in a follow-up article, we will give an overview of the key factors that can lead to exuberant price mark-ups in renegotiations and provide suggestions as to how competition can be used to reduce both the likelihood of renegotiations as well as renegotiation costs. We restrict ourselves to analysing negotiations not affected by destructive competition, i.e., the winning supplier makes a non-negative profit from the award under all presumable circumstances. This assumption holds for most Procurement projects.[1]

Industrial Economic View

Industrial economic theory does not predict an increase of overall prices as a result of a competitive negotiation design, as the following example shows:

Overall costs do not increase

Assume a profit maximising seller who participates in a competitive auction for a public construction contract for a concert hall. If the seller is awarded the contract and the negotiated price is binding, they must bear construction costs of EUR 50,000,000, otherwise they bear no costs. Abstracting from strategic considerations unrelated to the award itself, the seller has no reason to offer any price below EUR 50,000,000 as they would incur a loss. However, if price renegotiations after the auction are possible and the seller can expect to receive another EUR 10,000,000 due to upcoming renegotiation rounds, they  may submit an initial offer of up to EUR 40,000,00 to prevail against the competition in the auction. In both cases, the seller achieves an overall price of at least EUR 50,000,000.

The example illustrates that when renegotiations are expected to take place, offered prices may be lower in the initial negotiation due to competitive pressure. However, the overall costs do not increase as price mark-ups are already considered by the seller when making the initial offer. It is therefore crucial to make optimal use of competition in the initial negotiation to avoid higher overall prices.

Mark-ups don’t depend on the initial price

Furthermore, even when renegotiations are not expected but become feasible after nomination (e.g., due to technical change management and material price fluctuations), there is no reason to believe that renegotiation mark-ups depend on the level of the initially agreed price:

Assume that the seller has already accepted an initial price but an opportunity for price renegotiations arises. The seller now faces the decision as to whether they want to exploit their negotiation power as a quasi-monopolist after nomination and negotiate a price increase of EUR 10,000,000, or whether they accept a price increase of only EUR 5,000,000. In such a situation, any profit maximising seller will always decide to exploit their negotiation power and secure the maximum possible profit, independent of the level of the initial price.

Competition can help to lower costs

These two simple examples illustrate that whilst a competitive negotiation design may result in lower initial prices, it does not affect a sellers’ efforts to exploit their negotiation power after nomination. The motivation to do so exists regardless of the initial negotiation design and the initial prices agreed upon.  On the contrary, in such situations, competition can help to lower the overall Procurement costs, since it decreases the initial price level as a starting point for any renegotiation.

Behavioural Economic View

One objection against the arguments presented above is that sellers are not rational or profit maximising. Instead, they may incorporate fairness concerns and reciprocal behaviour into their decision-making process. Put differently, sellers expecting a financially pleasing outcome of a bilateral negotiation may be upset to find themselves in a highly competitive auction.

Tit-for-tat?

In turn, they play tit-for-tat. This game theoretical term describes that they take revenge for being placed in an auction by renegotiating more aggressively after nomination than they would have done had they won the tender in a bilateral negotiation. There are two strong arguments that oppose this view: Firstly, reciprocity usually only plays a minor role in corporate negotiation processes. Secondly, even under the assumption that reciprocity plays an important role, it may well be the case that a competitive negotiation design is considered fair and thus induces positive reciprocal behaviour.

There is extensive empirical evidence showing that professional buyers and sellers maximise profits more than private individuals do. Multiple reasons can explain this finding: Professional sellers and buyers are usually not operating with their own money and are therefore less emotionally involved when it comes to punishing their counterparts for unfair behaviour (Fehr and Fischbacher, 2004). Professionals are trained to make profit-maximising decisions favouring their own firm and are often monetarily incentivised to do so via profit participation. The amount of money on the table in such negotiations is large enough for income effects to become more important than fairness concerns (Sefton, 1992). Furthermore, the social preferences of professional buyers and sellers are influenced by their social identity, i.e., the company they identify with. Hence, sellers and buyers are more willing to accept distributional decisions deemed unfair and will reciprocate less if this will benefit their own company and colleagues (Kugler et al., 2007; Goette et al., 2012).

Transparent and fair rules matter

Moreover, even under the assumption that sellers act reciprocally if they are treated (un)fairly, it is unclear whether the outcome of a competitive negotiation design is considered unfair. The perception of a negotiation design as fair or unfair does not only depend on its outcome, but also on whether the rules of how to win the tender are transparent, unequivocal and do not favour any seller for non-justifiable reasons. A seller might thus consider a transparent, but nonetheless competitive negotiation design as fairer than a non-transparent negotiation design, even if the latter allows for higher revenues for the winner. Losing sellers in particular might consider a non-transparent negotiation design as unfair and reciprocate negatively, i.e., beless willing to cooperate.

This is particularly important in cases where buyers have long-term relationships with both winning and losing sellers. If the number of losing sellers outweighs the number of winning sellers, the impact of the negative reciprocity of losing sellers will likely off-set any potential positive effect arising from more co-operative winning sellers.

Outlook

So far, we have reasoned that neither industrial nor behavioural economic theory can explain the high price mark-ups in renegotiations seen after tenders with competitive negotiation designs. So, what can explain it? In our next article, we will give an overview about the key factors that can lead to exuberant price mark-ups in renegotiations and provide suggestions on how competition can be used to prevent it.