Tradeoff between Default Risk and Efficiency Loss

Abstract

The study characterizes an equilibrium bid function with three bidders in an average bid auction (ABA), where a winning bid is the one closest to an average of all submitted bids, when a cost overrun can occur, and an insolvent winner is penalized. First of all, every bidder bids an identical amount in the absence of the penalty. Meanwhile, when the penalty is charged high enough to prevent all bidders from breaching the contract due to cost overruns, either some bidders bid identically and the rest follow a strictly increasing bidding strategy, or all bidders place an identical bid. Based on the characterization, the ABA is compared to the first price reverse auction (FPA) in terms of a buyer’s benefit. The ABA could be more beneficial to the buyer without any penalty in spite of an insolvent winner’s default. If nobody defaults on his bid due to the high penalty, however, the FPA is good to the buyer. This result partly explains the rationale for the ABA in Italy. (JEL codes: C78, D82)