Pre-Auction Investments by Type-Conscious Agents

Abstract

This paper examines pre-auction investments made by asymmetric agents that compete for a supply contract from a monopolist principal. Agents are privately aware of their managerial efficiencies which determine how well they can leverage fixed investments to reduce their variable costs for servicing the contract, and they privately choose investment levels prior to the procurement mechanism being declared by the principal. Hence, the distribution of types that is standard in the principal-agent literature is, here, endogenously determined by the private actions of the agents. The principal declares a mechanism that is optimal for her, after agents have made their private investment decisions. We show that in equilibrium all optimal investment strategies by competing firms will have the form of investing as if there is no reservation price up to a critical level of managerial type, and investing minimally thereafter. This feature, however, implies that only trivial pure strategy equilibria can exist when the principal has any reasonably competitive alternative for servicing the contract. This is because in these cases an optimal mechanism induces agents to adopt a discontinuous investment strategy which provides the principal an incentive to deviate from the declared mechanism. An intuitive extrapolation of the extant literature to our context (in which agents adopt technologies featuring a fixed-variable cost trade-off) would suggest that we would see 'underinvestment', manifesting itself as lower fixed and higher variable cost technologies in the industry. However, this intuition is either sustained trivially or cannot be sustained in pure strategies when the principal has any reasonable outside options for supply. The question of what cost structure we will see in equilibrium in these contexts will require future effort, and a consideration of mixed strategies.