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Why combining e-auctions and game theory can deliver better results

Why combining e-auctions and game theory can deliver better results

Auctions offer maximum transparency for everyone involved. Suppliers have more flexibility, while buyers like using them to create competition and contact potential new suppliers. Experience from a series of projects has shown that incorporating elements of game theory can achieve even better results – as long as all the departments involved are on board and suppliers are qualified properly before invited to participate. All the more important because the outcomes of auctions are binding.

Unlike negotiations, there are no opportunities for backroom deals or side agreements in an auction; it’s just about the product that is actually for sale. And when it comes to e-auctions, social factors are taken completely out of the equation, with facts, figures, and data trumping sympathy, familiarity, and communication skills.

Two things are important here to ensure that this strategy delivers optimal results: Carefully preselecting suppliers will guarantee that only suppliers that can actually deliver the required quantities, prices, and quality levels can take part in the auction, and agreeing a strategic structure to the auction with the relevant departments will guarantee that the procurement goals are achieved. Incorporating elements of game theory when structuring the auction can add a significant boost.

Game theory is used as a theoretical model here, with participants (the players) attempting to anticipate the actions of other participants in a specific situation (the game). Depending on the conditions created for each situation, participants use a range of strategies to influence the game in their favor. In auction terms, the organizer structures the auction with the aim of achieving the best possible result, while the participating suppliers aim to win the item with the best possible profit margin for themselves.

Structuring the auction in line with procurement goals

Modern e-auction platforms can be configured to achieve procurement goals and incorporate elements of game theory, provided that the underlying auction strategy is based on those goals and has been carefully considered.

A combination of price, quality, and other variables such as delivery reliability is often far more decisive than price alone when bidding for an item. Other non-monetary goals – such as transparency throughout the delivery chain or compliance with required environmental standards beyond the legal framework – can also be incorporated into the auction structure.

Buyers also use a bonus/penalty system; for example, a supplier that offers the highest quality or carbon-neutral production is awarded a bonus, which is deducted from their bid price, while a supplier that has been unreliable in terms of quality in the past is given a penalty in the form of a price premium. This way of quantifying non-monetary goals ensures that bid prices can be compared objectively.

Putting game theory into practice

Auctions can be open or closed. In an open auction, suppliers can see who their competitors are and what prices they are bidding. In a closed auction, although participating suppliers can see the current best price and decide if they want to undercut it, but they don’t know who has actually made the bid. If the auction is held in a market where only a few major players are competing for orders, making the auction open can push suppliers a little bit further and improve the bids they make to the buyer.

The last call option is announced before the auction begins and is a way of unlocking further potential. Once the auction is over, the supplier that meets a specific criterion – such as the best starting bid before the auction – is given one last opportunity to undercut on price.

All these options are regularly used in auctions and are merely simplified examples of incorporating game theory. The aim is to make it more likely that the goals will be achieved and to guide participants in the desired direction, which is why the options used are always tailored to that specific auction. This may mean that a company buying two products at auction will hold two auctions with completely different framework conditions.

INVERTO has found that results from auctions incorporating elements of game theory can be 8-15% better than standard auctions. This approach can be used to buy MCO goods like packaging, as well as raw materials and semi-finished products.

Building confidence in departments and suppliers

Transparency, commitment, and openness about results are crucial for all auctions, however they are structured. The rules must be clear for all participants, and exceptions must not be made for anyone. Auction results are always binding, so arrangements must be made in advance with the departments about who is taking part in the auction. If the auction is won by an outsider or newcomer, there is no way of annulling that result afterwards and ultimately placing the order with the existing supplier.

To avoid internal disagreements in cases like these, buyers should implement thorough prequalification procedures for suppliers. The list of suppliers to be invited to the auction should also be agreed in writing with the relevant departments, along with the procurement goals. In some cases, this document is also sent to invited suppliers in advance, so they can be confident that the auction is being held under strict rules of play.

Whether suppliers see the auction concept as a risk or an opportunity depends on their role. New providers and those that have not yet managed to win anything will view it as an opportunity, while existing suppliers may see it as a risk to what was as a secure position. Transparency is particularly important here to avoid frustration and loss of confidence.
Conclusion

Linking game theory and e-auctions is nothing new in the automotive industry, and the concept has also been used in many countries to sell mobile communications licenses. Here at INVERTO, experience has shown that two things are crucial for auction success: structuring the auction around specific goals chosen in consultation with the relevant departments and only allowing qualified suppliers to take part.

Find out more here about how to find the appropriate digital tool for auctions and other procurement fields.

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