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The Tendering Process in the Construction Industry:

Introduction: The Strategic Situation

The tendering process within the Construction Industry is a first-price sealed-bid auction with
multiple stages, and involves interaction between the employer, main (general) contractors,
and subcontractors. The employer could be the Government tendering for a new school, or a
firm requiring new commercial premises. The main contractor is responsible for the entirety of
the building or civil engineering project and may or may not have specialist skills relating to
the prospective project. In addition, a main contractor will utilise their own engineers, site
foremen and machinery and the like. A main contractor may hire subcontractors to undertake
certain aspects of the work, particularly if they lack the necessary infrastructure to carry out
such aspects (i.e. asphalt or drainage). For the purpose of our discussion, we will be dealing
with the initial stage of the auction where we have one employer and a number of main
contractors. The employer will send out an invitation to tender1 to each of the prospective
tenderers, inviting them to submit a bid for the completed works. This is a relatively informal
stage and does not signify the formation of a legal contract per se. However, by submitting a
bid, the main contractor is agreeing to carry out the work at a given price. In accordance with
auction theory, we will assume that given this is a first-price sealed bid auction, and thus the
tenderer offering to complete the project for the lowest price will be awarded the work.
However, as we will discuss, this may not always be the case.

Upon receipt of the bill of quantities, the procurement department of a main contractor will
price everything required to complete the prospective project. The object of this stage is to
submit a bid that is sufficiently low in order to win the job but sufficiently high to protect profit
margins. Once the job has been awarded to a contractor on account of the first-price
submitted, that contractor then refers back to the materials firms from which it initially received
prices in an attempt to secure a profit. As a result, the contractor will not push too hard in the
first instance. It becomes apparent, therefore, that the contractor purchases materials at a
given price, and when these materials (along with skills and expertise) are brought to site, the
owner is charged a higher price. Moreover, a general trend is that subcontractors and firms
selling building materials will quote a lower price once a contract has been awarded, as
opposed to it being at tender stage. However, in an effort to gain work, a contractor may bid
too low and thus not make a profit on the project, ultimately giving rise to the winners curse,
resulting from the problem of adverse selection. This essay will discuss the winners curse in
relation to the construction industry, and how this can be corrected in terms of auction design.
Moreover, to be discussed is the presence of collusion and phantom bidding in the tendering
process, along with the problem of bid rigging. We will discuss the problems resulting from
the current design throughout this essay, and provide suggestions for how the design could
be altered in an attempt to prevent such problems.

1
Included in this will be a bill of quantities. This is a list of everything required to complete the job. Moreover,
included in the invitation to tender is the terms of the tender, which will outline provisos, such as the contractor
must adhere to his bid price.

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The Winners Curse

The tendering process within the construction industry has certain caveats, one of which is
the scope for the winners curse. This involves a main contractor agreeing to carry out the
work for a price such that they are unable to make a profit, or indeed, for a price they would
not normally bid. As Dyer and Kagel (1996, p.1463) highlight:

Construction contract bidding is usually treated as a common value auction. In a pure

common value auction the value of the item is the same to all bidders. What makes
the auction interesting is that bidders have difference estimates of the true value at the
time they bid. Assuming that bids decrease with decreasing cost estimates, the low
bidder faces an adverse selection problem, as he/she wins only when he or she has
one of the lowest estimates of the cost of construction. Unless this adverse selection
problem is accounted for in bidding, the low bidder is likely to suffer from a winners
curse, winning the item but making below normal or even negative profits.

Whilst theory suggests that the current tendering process favours larger, more efficient firms
able to internalise the costs of operating in a new construction market, project auctions in the
construction industry may not, in reality, operate on a strictly first-price sealed bid basis. In
reality, who wins the contract may also be based on previous encounters between owner and
tenderer, the reliability of a firm, and the quality of previous work. Repeated interaction could
give rise to reciprocity, and perhaps an owner would be prepared to pay slightly more for a
finished project if it is completed in a timely fashion and the quality of the work is high.
Furthermore, there is a mutual benefit to both owner and contractor of avoiding the winners
curse. Dyer and Kagel (1996) argue that no employer will want a tenderer to fall subject to
the winners curse as there is an on-going relationship, dependent on completion of the
work, which may not be possible if the tenderer runs out of funds. In addition, as Dyer and
Kagel (1996) highlight, the owner can fall subject to an owners curse in choosing the lowest
bidder, particularly if the bidder is a smaller, relatively inexperienced firm, and the amount of
money on the table2 is large. As a result, more often than not, main contractors are able to
withdraw their bids without financial repercussions.

An issue with the current auction design, which exacerbates the winners curse is the issue
of what Dyer and Kagel (1996) term bid shopping. In theory, we assume that the tendering
process is a sealed bid auction, meaning that tenderers are only aware of their bid and not
the bids of rivals. However, a problem in the construction industry is a main contractor
revealing the bids of subcontractors to their competitors in order to drive down bids. This
creates a tendency for the bidding process to turn into a traditional English auction, thus
disadvantaging subcontractors. A trend throughout the literature is that bid shopping leads
construction firms to refrain from submitting bids at a time other than right before the deadline,
thus minimising the likelihood of their bid becoming common knowledge. This will be
discussed further when we analyse the possibility of a sequential auction design.

2
The difference between the winning (lowest) bid and the second-lowest bid.

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Collusion and Repeated Interaction

Repeated interaction between firms can facilitate collusion. Gupta (2001) finds that non-
competitive behaviour can become apparent in accordance with the Bertrand competition
model. If the loss arising due to defection on a collusive agreement (due to a price war)
exceeds the gain that can be made from defection at a given point, collusion is said to be
sustainable (Gupta, 2001). There are two notable forms of corruption that can arise in sealed
bid auctions, these being bid rotation and phantom bidding. The former occurs when there
are a number of firms (i.e. six) involved in the tendering process, and only one firm places a
bid. Inevitably, this enables the title of winner to be rotated among these six firms, such that
they each take it in turn to bid alone, unrivalled. This form is not common in the construction
industry as unrivalled bids scream non-competition. A more realistic and apparent form of
collusion is phantom bidding, which centres around, for example, five firms bidding artificially
high, whilst one firm bids comparatively low, though high enough to ensure a sufficient profit.
This is designed to provide competition agencies with a veil of competition, though beneath
the surface this collusive agreement leads to much the same outcome as that of bid rotation.
Gupta (2001) uses data from the Florida Highway procurement auctions between 1981 and
1986, during which 8943 bids were made on 1738 projects. He reports that the mean of all
submitted bids (BID) throughout these auctions is nearly 70% higher than the mean winning
bid (WBID), thus pointing towards the existence of phantom bidding. Moreover, Gupta
(2001) finds evidence of firms bidding above average costs, with the mean winning bid being
8% higher than the mean estimated cost. This provides further evidence for the idea that
contractors attempt to escape the winners curse.

Gupta (2001) assumes a private value auction, meaning that each bidder knows his own
valuation of the project, but not that of his competitors. There is evidence for a considerable
amount of repeat bidding in the Florida auctions, and Gupta (2001, p.462) finds that
measures of multiple contact3 support the hypothesis that repeated interaction enhances
collusive activity. Ultimately, research by Gupta (2001, p.463) displays a noticeable effect of
the number of bids on the winning bid and the low bid cost ratio, and he reports that repeated
interaction results in higher bid prices. Moreover, Gupta (2001) finds that collusion is more
apparent where larger projects are concerned, again highlighting an apparent advantage to
larger firms. A possible remedy for this issue is the use of sequential bidding.

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MLC1, MLC2, and MLC3 (see Table 1 in appendix).

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Sequential Bidding

As previously mentioned, there is a problem of bid shopping present in the construction

industry, and sequential bidding could rectify this. De Silva et al. (2002) analyzed the bidding
patterns of 213 firms during the Oklahoma Department of Transport auctions from 1998 to
2000. They analyzed the bidding patterns in morning and afternoon auctions of construction
contracts and the effect the morning result had on the firms actions in the afternoon. The
release of the morning result allowed potential bidders to alter their bids or their decision to
participate in the afternoon session (De Silva et al, 2002, p240). The probability of a firms
participation in an auction depends on independent variables such as project characteristics
like the states estimate of engineering cost and use of dummy variables to determine project
type. One must also take into account the bidders own characteristics and include a variable
that describes capacity commitment (backlog). Moreover, bidders utilise past information on
the bidding success of rivals to gauge the competitiveness of a potential set of rivals.

Source: De Silva et al, 2002, p242

Source: De Silva et al, 2002, p243 4

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Since the opportunity cost of completing a project varies between potential contractors (De
Silva et al, 2002), the regression model must be developed to allow firm-time period effects to
control for the differences in unobserved heterogeneity between various firms. The regression
analysis suggests firms that submitted unsuccessful bids in the morning auction tended to bid
more aggressively in the afternoon. In addition, when a weak bidder is facing a strong bidder,
as opposed to another weak bidder, there is a tendency to bid more aggressively (De Silva,
2002).

Conclusion

There are many factors that determine a successful bid within a construction auction. One
can suggest that the tendering process is not a common value auction. Each firm faces their
own backlogs and opportunity cost when undertaking a new project and thus one can
suggest the tendering process is a private value auction. Other factors such as previous
relationship with the employer, reliability and the previous quality of work also determine
bidder success. For some firms, the winners curse is unavoidable in order to retain the
services of a good workforce. A firm may bid unusually low in order to win a contract purely
for the purpose of keeping site foremen employed (Dyer and Kagel, 1996).

As discussed, collusion is a problem in this auction mechanism, and repeated interaction can
facilitate bid rigging (Gupta, 2001). Moreover, the problem of phantom bidding is all to
prevalent, with artificially high bids seemingly representing the existence of competition.
Collusion appears be more apparent in larger construction projects, thus presenting an
advantage to larger firms.

To what extent could another auction type provide a solution to collusion? A Dutch auction
(with ascending bids) may counter the issue of collusion, and would eliminate a downward-
spiralling price war. Collusion would not be sustainable in the case of a Dutch auction, as
there would be an incentive for a contractor to deviate from the collusively agreed (higher) bid.
This would involve one firm winning the contract by agreeing to complete the project for a
lower bid, ultimately receiving a lower profit. However, leaders of the construction industry
claim that large-scale contracts are too complex to be judged on price alone (Construction
News, 2002).

WORD COUNT: 2058

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Appendix

Appendix A The Effect of Bid Rigging on Prices Gupta

Descriptive Statistics Table

Source: (Gupta, 2001, p461).