How to Award Contracts When You’re Concerned about Quality

The stakes are particularly high when the quality of your purchase is important but also difficult to write into a contract.

“You might have this issue when a person or an organization is trying to purchase a good whose quality is unknown to them, and they cannot verify it except maybe only later in the act of consumption,” says Nicola Persico, a professor of managerial economics and decision sciences at the Kellogg School.

Think about a government wanting to build a new road, a warehouse looking to install a refrigeration system, or even an individual in need of a decent haircut. By the time a buyer can reasonably gauge the quality of what they’ve purchased, well, congrats! It’s already theirs, and there’s no going back.

“Maybe in two years the road will start cracking,” says Persico. “And then it’s too late.”

In situations like these, many common procurement practices—like holding auctions where the lowest bidder gets the job—aren’t ideal. “If you assigned the contract to the lowest bidder, probably the lowest bidder is going to do a shoddy job, and that’s going to end up costing you much more later,” says Persico.

In new research with Giuseppe Lopomo of Duke University and Alessandro Villa of the Federal Reserve Bank of Chicago, Persico demonstrates that the optimal way to find a supplier when you have quality concerns is to set a floor price under which bids will not be considered. That prevents higher-quality suppliers from being outbid in the bidding process and in turn decreases the likelihood that the contract will go to a supplier that’s shady or underqualified.

The lemons problem

In economics, the “lemons problem” is widespread and vexing. Whenever sellers know more about the quality of a good or service than do buyers, there is a risk that the market will be flooded with lemons: poor-quality products that the buyer never would have purchased knowingly. After all, why should a seller bother to go the extra mile (and spend the extra money) to create a superior product when they can sell a shoddy one for the same price?

Plenty of solutions for this conundrum have been proposed. For instance, some buyers demand robust seller warrantees. Other buyers rely on a seller’s strong reputation, or on trusted relationships developed over the course of many transactions, to feel assured that they are making a quality purchase.

But these options are not always possible. Indeed, says Persico, “even if you have a long-term relationship with a supplier, there may be other constraints that prevent you from acting on that information.” For instance, many governments, including the European Union, must abide by anti-corruption or anti-collusion policies that prevent them from making procurement decisions based on any stipulation that isn’t specified in a contract.

“You have to award the contract to the lowest bidder for transparency reasons,” says Persico. “And you can imagine the disasters that follow from this! You’re going to have fly-by-night operations starting up with a post-office box and bidding for contracts.”

So in the absence of any great way to ensure quality—and with the lowest bids likely to come from the most suspect suppliers—what’s a buyer to do?

A quality–price trade-off

In their paper, Lopomo, Persico, and Villa propose that buyers use a lowball lottery auction, which they affectionately call LoLA. At first, LoLA resembles another popular kind of auction, where the buyer sets the price high and then gradually drops it over time, with bidders leaving the auction until only a final bidder remains.

“So it works the same way, except that the price will not go down to zero,” says Persico. Instead, the buyer will set a minimum price—a floor—below which they will not accept bids. The winner will then be selected randomly among any bidders still in the auction.

This floor price used in the auction is calculated on a case-by-case basis, allowing the buyer to optimally balance their own desire to save money (which would lower the floor price) against their need for a high-quality supplier (which would raise the floor price).

“There’s a trade-off,” says Persico. “The entity auctioning off the contract wants to pay less; they want an aggressive bid, a low bid. But at the same time, they’re concerned that if the bid is too low, the bidder may be a fly-by-night operator. And so the analysis asks, ‘How do you resolve this contract optimally?’

Italian roads

So, adopting a LoLA seems like a smarter procurement strategy, at least in theory. But just how much do buyers really have to gain from making the switch?

To demonstrate LoLA’s real-world impact, the researchers accessed data from Italian government procurement auctions, looking specifically at those contracts that had been awarded to the lowest-price bidder. Then they conducted a counterfactual experiment, estimating how these municipalities would have fared if they had used a LoLA instead. “So we say, ‘Okay, suppose instead of giving the contract to the lowest bidder, you had used our mechanism,’” says Persico.

They did this by analyzing data about the quality of the goods or services that the suppliers delivered—in this case, whether there were any delays or cost overruns—and then estimating how the same scenario would have played out if the governments had used an optimal floor price for each auction instead.

Their finding? Setting a floor price would have cost the government a bit more money upfront. But in the long run, once you take into account the costs associated with overruns and delays, the government ultimately would have ended up saving money. The savings weren’t huge—a few percentage points—but cumulatively and over many large expenditures, “even modest savings make a difference,” says Persico.

Extra benefits

In addition to being an optimal strategy for buyers who care about balancing quality and cost, LoLA can also be an optimal strategy if all you care about is quality. The difference is that the floor price would be set higher—reflecting less cost-consciousness.

LoLA has another advantage, too. In the absence of a floor price, attracting more bidders to an auction tends to worsen the lemon problem, as the extra competition further depresses prices and dissuades quality vendors. But with a floor price, “you can always take advantage of the positive aspects of competition without the negatives,” says Persico. “That floor prevents these very poor bidders from getting the contracts.”

And LoLA isn’t just useful for public-sector procurement.

“If you’re sourcing ingredients for your private food company, you can imagine there’s going to be cheap suppliers and expensive suppliers, and of course the expensive suppliers are going to say that the cheap suppliers are going to be lower quality. But if you don’t know,” says Persico, “you might want to use the auction format we propose.”

In fact, Persico and his colleagues are actively looking for companies that fit this bill. In return for data sharing, they would be willing to offer some free consulting.

“Anyone reading this in a private company who has this problem should contact me,” he says.