Competition to reduce unbalanced bidding

Svante Mandell* and Johan Nystrm**

March 2016

Abstract

Several sectors, especially the construction industry, use unit price contracts (UPC). In the
procurement phase, ex ante, this contracting form provides agents with estimated quantities of the
work to be done. Competing agents then offer corresponding unit prices i.e. the bid is a price
vectors and most often the lowest vector sum is awarded the contract. This way of procuring is
transparent but also entails a potential problem of unbalanced bidding. Unbalanced bidding occurs
when an informed agent skew unit prices in order to win the ex ante bid. The concept is not new
topic in research, but theoretical models from an economics perspective are not extensive. This
paper will focus on how competition among informed bidders will affect the optimal solution. It is
shown that skewing is still a dominating strategy under competition. However, competition will
decrease, but not necessarily eliminate, information rents. In this setting, unbalanced bidding could
mainly be seen as a way to win the contract and not to extract information rents. Thus, it does not
constitute an efficiency problem for the client.
Keywords: Unbalanced bidding, modelling, unit price contracting, public procurement

Royal Institute of Technology (KTH) and Swedish National Road and Transport Research Institute (VTI)
Corresponding author: VTI and Centre for Transport Studies (CTS) Box 55685 / SE-102 15 Stockholm /
Sweden. Tel: +46-8-555 365 07 Johan.Nystrom@vti.se
*

**

Introduction

Governments using unit price contracts (UPC) in public procurement run the risk of receiving
unbalanced bids. In UPCs, the client provides a bill of estimated quantities and the bids consists of
corresponding unit prices. Informed bidders can skew unit prices in order lower the ex ante bid and
allegedly raise the ex post profit.
Literature on this topic shows us that informed bidders have an incentive to skew bids (De Silva,
2015; Mandell and Nystrm, 2013, Ewerhart and Fieseler, 2003; Athey and Levin, 2001). If bidders
are risk-neutral, they will end up in corner solution i.e. bids with zero prices (Ewerhart and Fieseler,
2003; Athey and Levin, 2001). Assuming risk-averse bidders provide an internal solution (Mandell
and Nystrm, 2013).
The existing models do however somewhat neglect the effect of competition on skewing. This paper
focus solely on how competition amongst informed bidders will affect unbalanced bidding and the
entailing information rents.

Low tenders in public procurement

From a tax payers perspective low prices in public procurement are usually seen as something
good. Along with improved quality, low prices are the purpose of public tendering. However,
problems can occur from, so called, abnormally low bids. Versions of this problem include predatory
pricing, winners curse or unbalanced bidding.

The discussion of predatory pricing is said to have started in the mid-1970s with a paper by Areeda
and Turner (1975). Predatory pricing refers to a situation where a financially strong contractor
submits a price below marginal cost with the purpose of driving competitors out of business. This
is usually referred to a situation where the firms dump prices to end consumers. The concept is
also applicable in public procurement, where a financially strong competition deliberately accepts
a loss in order to scare off competitors regarding the next procurement. Such a bidding behaviour
is illegal in most western countries. Another version of predatory pricing, which is more relevant to
public procurement and not clearly illegal is to submit a low bid in the tending process with the
intention of making money through changes and extra work.

Abnormally low bids can also be a symptom of the winners curse (Capen, Clapp, and Campbell
1971). In contrast to predatory pricing, this is not a case of a deliberate or strategic action. The
winners curse stands out in being a consequence of an ignorance or lacking information, by bidding
below the actual cost for delivering the contract. This type of problem is hard to detect for the client
and problematic for both parts ex post.

Unbalanced bidding can only occur in unit price contracts (UPC) and stems from the contractor
having superior information compared to the client. There are three types of unbalanced bidding,
front-loading, back-loading or individual rate loading (Su and Lucko, 2015). Front-loading means
that unit prices will be raised on item undertaken early in the project, in order to improve cash flow.
The opposite strategy of back loading could be interesting in a long project with high inflation in the
start of the project. Individual rate loading (or error exploitation) concerns asymmetric information
between client and bidders regarding the ex ante estimated bill of quantities. If a bidder knows that
some quantities are overestimated and others underestimated, there is an incentive to lower the
price of the former and vice versa. This will lower the ex ante bid and increase the profit ex post.
Mandell and Nystrm (2013) also show that quantity deviations in different directions in not a
necessary condition for unbalanced bidding. There is also an incentive to raise the price on relative
underestimated quantities. Unbalanced bidding in this paper refers to individual rate loading.
2

Earlier studies on unbalanced bidding

The research literature on unbalanced bidding can be divided into three categories, two model
based and one empirical.
The first one is of practical usage, assisting clients in detecting skewing (Arditi and Chotibhongs
2009; Wang, 2004) and bidders in optimising their bids (Su and Lucko, 2015; Cattell et al., 2008,
2010; Yizhe and Youjie, 1992).

A second type of papers, takes an efficiency approach from an economics perspective. This
category includes three papers. Ewerhart and Fieseler (2003) model a UPC with two inputs: material
and labour. In equilibrium their risk neutral informed bidder will submit zero unit prise for the
overestimated task i.e. a corner solution. Athey and Levin (2001) take inspiration from timber
auctions, bidding for harvest rights. Like the above paper, optimum is found in a corner solution
with a zero unit price. The models differ what type of information is asymmetric. Ewerhart and
Fieseler (2003) have the bidders better informed about their own type (fast or slow), while Athey
and Levins (2001) bidders have better information than the auctioneer about the tract to be sold.
Mandell and Nystrm (2013) model risk averse bidders in road construction and end up in an
internal solution i.e. not extreme skewing to zero-bids.
The third type of studies include empirical studies on the existences of unbalanced bidding, all
using data from road construction. Although not the focus of the paper, Bajari et al (2014) show
that a 10 percent quantity overrun will raise the corresponding unit price with 0.5 percent. Nystrm
(2015) using data from Swedish road construction and De Silva et al (2015) using data from road
construction in Texas, US do not find any correlation between deviations in quantities and prices.
This confirms Skitmore and Cattells (2013) view that there is not an overwhelming amount of
empirical studies confirming that unbalanced bidding is a problem.

One issue that is lacking in both the theoretical and the empirical literature of unbalanced bidding
is how competition will affect skewing. The intuitive answer is that it will reduce information rents
by less skewing, as competition usually is a panacea for solving inefficient solutions. However, it is
not obvious how since skewing always is a dominating strategy ex ante. The following section will
provide a formal model to highlight the mechanism through which competition will reduce the
problem of unbalance bidding.
An unbalanced bidding model with competition
In the following section we develop a model, using a similar framework as in Mandell and Nystrm
(2013), which in terms draws from Athey and Levin (2001). In contracts to these models, we
assume that the informed contractors all have identical information and the same marginal cost.

Assume that two tasks, A and B, are required to produce a product, e.g., a road. Let A be the quantity
of task A specified in the contract and B be the specified quantity of B. Task A is potentially
incorrectly specified by the client. We assume that an informed contractor knows the quantity of
A actually required. Let this be A + . The assumption of there only being two tasks is not restrictive,
the basic mechanism will be the same disregarding the number of tasks. Similarly, that only one
task is incorrectly specified by the contractor suffices to capture the relevant aspects of unbalanced
bidding (see Mandell and Nystrm 2013).
We restrict our attention to Unit Price Contract Procurements under which the client specifies
quantities for A and B respectively. A contractor is bid consist of per unit prices on A and B, denoted
PA,i and PB,i. The contractor with the lowest total price, PA,i A + PB,i B, wins.

Conducting each task is assumed to be associated with a constant marginal cost, denoted
and
respectively. The informed contractors total cost for task A is given by
= (A + ) and for B
it is
= B. The profit (or net payment), r, received is given by:
=(

Where

and

)(

)+(

(1)

denote contractor is per unit bid for tasks A and B respectively.

As will be shown, an informed contractor will let its superior information influence the bid prices PA
and PB. There are three restrictions limiting the degree to which the bids may be skewed. Firstly,
the profit, r, cannot be negative i.e. we do not allow the informed contractor to engage in predatory
pricing. Secondly, neither bid must be negative, i.e.,
0 and
0 Thirdly, the total bid, i.e.,
PAA + PBB, must be (weakly) lower than the lowest bid placed by the competing bidders to win.

Let us denote the lowest competing bids as

and
for task A and B respectively (L for lowest).
The total bid from the lowest competing bidder is thus
+
. We may then write a bid
restriction which must be fulfilled for the informed contractor to win the procurement as:
+

Which may be rearranged into an expression for is bid on B as a function of the bid on A:
P

+P

(2)

(3)

We will subsequently assume that (3) is binding, as a strict inequality implies leaving unnecessary
surplus to the procurer. Thereby, we may use (3) to substitute for the informed contractors bid on
B, thus allowing us to optimize over the bid on A only.
As opposed to Nystrm and Mandell (2013), we let all contractors be informed. Thus, the
competition will drive their bids down to zero expected profit. Even so, this does not imply that they
bid their marginal cost as they all face incentives to skew their bids given the information they have.
To see this, assume that all contractors bid their marginal costs. Using (1) and (3) together with
=
and
=
(assuming all contractors have identical constant marginal costs) we have
the following expected profit function:
=(

)(

)+(

+C

(4)

Differentiating (3) with respect to P yieds

=

(5)

Thus, given that all other contractors bid their marginal costs, the profit for contractor i will be
increased if the unit bid for task A is increased if > 0 (i.e., the quantity is underestimated by the
client) or decreased if < 0 (overestimated by the client). The only thing holding back is the
restriction that no bid may be negative. So, if < 0, the expected profit will be maximized when the
unit bid for A is zero. Similarly, if > 0, it becomes optimal to set the unit bid for B to zero to provide
room for an as high unit bid on A as possible.
Thus, when the competing contractors set their bids equal to marginal cost, it is optimal to skew
the bids such that the profit becomes strictly positive even though the total bid is such that the
4

procurement is won. However, this cannot be an equilibrium if all contractors are informed, simply
because all contractors then face incentives to skew their bids.
The outcome, given this stylized setting, will rather be that all contractors skew their bids fully. That
is, if > 0, they will all set the unit bid for B to zero. This creates maximum room for increasing the
unit bid on the underestimated task A. However, if the competition is strong enough the profit will
be forced to zero and this will determine the unit bid on A. To find an expression for the unit bid on
A, we start with equation (1), assuming all contractors to be identical, and enter a unit bid for B
equal to zero, that is, full skewing, along with zero profit:
=0=(

)(

) + (0

We may then express the optimal unit bid on A as

(6)
(7a)

Equation (7a) shows that the optimal unit bid on A is the marginal cost for task A plus a mark-up
that depends on the marginal cost for task B and its true relative share of the total tasks to be
conducted in the project. The corresponding expression for the unit bid on B in the case when <
0, where the unit bid on A is zero, is

(7b)

The general insight is that competition will force profits to zero. Even so, the incentive to skew the
bids remains. Consequently, the individual bids do not correspond to the contractors marginal
costs, but the total bid will amount to the same value as if they did. They are bound by the revenue
function not being negative, but need to skew as much as possible to win the contract.

We have used several simplifying assumptions. That having only two tasks out of which only one is
incorrectly specified by the client suffices to capture the general problem has been discussed
above. If uncertainty is introduced together with risk averse contractors, we know from Mandell and
Nystrm (2013) that we should expect an interior solution, i.e. not the corner solution where one
(or more) tasks are given a bid-price of zero. This is because bid-skewing exposes the contractor
for risk if the estimate of the quantity turns out to be wrong. However, the bid skewing is still optimal,
but not to the same degree as in a deterministic setting. Thus, the basic insights above will apply.
The assumption about constant marginal costs is rather strong, but simplifies the model and do
not affect the qualitative outcome of the model.
Hence, the model has shown that competition will reduce profit to zero, but skewing will still be
evident. Competition among the informed contractors will reduce information rents but is not a
guarantee for eliminating these rents. This is dependent on the marginal cost of uniformed
contractor, as shown in the example below.

A numerical example of the model

The model above can be illustrated with the following numerical example regarding e.g. road
construction. As in the model, there are two inputs to build a road tunnel, e.g. paving and
excavation. The ex-ante bill of quantities provided by the client estimates 100 m2 of pavement and
100 m of excavation through the mountain. There are three contractors bidding for this contract.
Two of them have superior information about the length of the tunnel, compared to the client and
5

contractor 3. The contractors with superior information have the same marginal costs, that are
higher than the uninformed contractors, as shown in table 1.
Table 1. Ex ante bill of quantities and estimates
Clients bill
of
quantities

Contractor 1s
estimation of
quantities and
MC
(informed)

Contractor 2s
estimation of
quantities and
MC
(informed)

Contractor 3s
estimation of
quantities and
MC
(uninformed)

Pavement
(paving)

100 m2

100 m2

100 m2

100 m2

Tunnel
excavation

100 m

120 m

120 m

100 m

MCpavement

10

10

MCexcavation

10

10

In a case with only one risk-neutral informed client, the profit maximising bidding strategy would be
to price pavement zero and excavation 18 - (see Athey and Levin, 2001 and Ewerhart and Fieseler
(2003) for optimal corner solutions). This corner solution is bound by the uninformed contractors
bid of 1 800.1
However, with two informed contractors this is not an equilibrium, as there is an incentive to
undercut each other. As seen in equation 7a-b, the undercutting will go on until the same total price
as the marginal cost bid occurs. In this numerical example, prices will be zero for pavement and
16,67 for excavation, see table 2

100x9+100x9=1800, where the informed contractor would bid 100x0+100x18=1800.

Table 2. Ex post quantities and revenues

Actual
quantities

Contractor 1s
revenue (informed)

Pavement
(paving)

100 m2

100x0=0

100x0=0

100 m2

Tunnel
excavation

120 m

16,67x120 =

16,67x120 =
2 000

9x100
+9x120=1980

2 000

2 000

1 980

Final cost
for client

2 000

Contractor 2s
revenue (informed)

Contractor 3s
revenue (not
informed)

Say that the informed contractors were right in their estimations of excavation, which would yield a
revenue of 2 000 as seen in table 2. The superior information compared to the low cost contractor,
enables the informed contractors to win the contract and extract inefficient rents of 20. Skewing
will be bound by the restriction that profit cannot be negative. Hence, in the case of a low cost
uninformed contractor and competing informed contractors, skewing and extracting information
rents will be undertaken.

Conclusion
The main argument against unbalance bidding has been that clients (often with taxpayers money)
end up paying too much. There is also a discussion of unbalance bidding being unethical, raised by
e.g. The Ethical Council for the Swedish Construction Sector. Hence, unbalanced bidding is usually
portrayed as something problematic for the client. Models have been developed and adapted to
detect skew bids with the intention of rejecting them. The Federal Highway Administration (FHWA)
in the US has a template for the State Departments of Transportation on how to investigate
unbalanced bidding (FHWA, 2000).
However, complementary to the lack of empirical support for unbalance bidding being a problem,
we show that competition reduces inefficient information rents and the problem of clients paying
too much. Skewed bids could be seen as solely a way to win the contracts ex ante and not
necessarily composing an inefficient equilibrium. Hence, rejecting skewed bids, that are results of
fierce competition between informed contractors might not improve the socially most beneficial
outcome.
This paper suggests that unbalance bidding primarily is a way for informed bidders to win the ex
ante contract and not a way to ex post extract information rents.

References

Areeda, P., and Turner, D.F (1975) Predatory Pricing and Related Practices under Section 2 of the
Sherman Act, Harvard Law Review, 88(4), 697-733.
Athey, S., and Levin, J. (2001) Information and Competition in U.S. Forest Serve Timber Auctions.
Journal of Political Economy, 109 (2): 375417.

Arditi, D., and Chotibhongs, R. (2009) Detection and prevention of unbalanced bids. Construction
Management and Economics, 27 (8): 721732.
Bajari, P., Houghton, S. and Tadelis. S. (2014) Bidding for Incomplete Contracts: An Empirical
Analysis of Adaptation Costs. American Economic Review, 104(4), 1288-1319.
De Silva, D.G, Dune, T, Kosmopoulou, G. and Lamarche, C (2015) Project Modifications and
Bidding in Highway Procurement Auctions. FRB Atlanta Working Paper No. 2015-14
Capen, E. C., Clapp, R. V. and Campbell, W. M. (1971) Competitive Bidding in High-Risk
Situations. Journal of Petroleum Technology, 23, 641-653.

Cattell, D.W., Bowen, P.A. and Kaka, A.P (2008) A simplified unbalanced bidding model.
Construction Management and Economics, 26, 12831290.

Cattell, D.W., Bowen, P.A. and Kaka, A.P (2010) The risks of unbalanced bidding. Construction
Management and Economics. 28 4: 333344.

Ewerhart, C. and Fieseler, K., (2003) Procurement auctions and unit-price contracts. Rand Journal
of Economics, 34 3: 569581.
FHWA (2000) Work Plan for Investigation of Unbalanced Bidding

Mandell, S. and Nystrm, J. (2014) Too much balance in unbalanced bidding. Studies in
Microeconomics, 1, 23-35.
Nystrm, J. (2015). The Balance of Unbalanced Bidding. Procedia Economics
and Finance, 21: 97-103.

Skitmore, R.M. and Cattell, D. (2011) On being balanced in an unbalanced world. Journal of the
Operational Research Society. 64, 138146.
Su, Y and Lucko, G (2015) Synthetic cash flow model with singularity functions for unbalanced
bidding scenarios. Construction Management and Economics, 33(1), 35-54.
Yizhe, T. and Youjie, L., 1992. Unbalanced bidding on contracts with variation trends in clientprovided quantities. Construction Management and Economics. 10, 6980
Wang, W. (2004) Electronic-Based Procedure for Managing Unbalanced Bids. Journal of
Construction Engineering and Management, 130:3, 455-460.