Bid Preference Programs and Participation in
Highway Procurement Auctions
January 2010
Abstract
We use data from highway procurement auctions subject to California’s Small Business
Preference program to study the effect of bid preferences on auction outcomes. Our analysis
is based on an estimated model of firms’ bidding and participation decisions, which allows us
to evaluate the effects of current and alternative policy designs. We show that incorporating
participation responses significantly alters the assessment of preferential treatment policies.
Keywords: Bid preference programs, auction participation, asymmetric bidders.
JEL Classification: D44, L10, H11, H57
1 Introduction
Public-sector procurement accounts for over 10% of U.S. GDP. Across levels of government,
preferential treatment programs are extensively used in procurement auctions. For example, in
2006, the federal government awarded 20% of its procurement dollars to favored firms.
1
One
commonly used preference mechanism, a bid discount or credit, improves the bids of favored
firms by a pre-established rate when determining the winner, but uses the actual amount of the
winner’s bid in the contract.
2
Prominent examples include a 25% bid credit granted to small firms
in FCC spectrum auctions and a 50% bid penalty added to foreign bids on defense contracts.
3
The aim of this pap er is to improve our understanding of the effects of such preference programs
on the government’s cost of procurement and the distribution of profits between participants, as
well as to provide an assessment of the likely magnitudes of these effects in practice. We do so
empirically in the context of the California Small Business Preference program that grants small
firms a 5% bid discount.
4
The stated goal of most preference programs is to facilitate the integration of favored
participants into the market place. These are often groups historically discriminated against, or
groups considered disadvantaged due to entry barriers, or both. They are also often considered
to be less cost efficient. As preference programs result in such high-cost companies performing
a larger share of work, one may expect the cost of procurement to increase. At the same time,
however, these programs also provide incentives to non-favored firms to bid more aggressively
against the strengthened favored group, which mitigates the upward pressure on the cost of
procurement. For some discount levels, this last effect is sufficiently strong for the cost of
procurement to actually decrease (McAfee and McMillan (1989) and Corns and Schotter (1999)
show this theoretically and in experiments, respectively, for assumed numbers of bidders and
cost distributions).
The key insight of this paper is that there is a third effect neglected in the literature.
Bid preference programs have potentially strong effects on firms’ incentives to participate in
1
See the Federal Procurement Report 2007, available at https://www.fpds.gov/.
2
With a 10% bid discount, for example, a bid by a favored firm of $440,000 is treated as a bid of $400,000
in comparing it to the remaining, non-favored, firms’ bids. If the favored firm wins, its payment is the original
amount of the bid, or $440,000.
3
See “Implementation of the Commercial Spectrum Enhancement Act and Modernization of the Commis-
sion’s Competitive Bidding Rules and Procedures,” WT Docket No. 05-211, Second Report and Order and
Second Further Notice of Proposed Rulemaking, 21 FCC Rcd 4753, 4766 par 36 (2006); and the Department of
Defense’s “Defense Federal Acquisition Regulation Supplement,” Part 225: Foreign Acquisition (2008), available
at http://www.acq.osd.mil/.
4
Other empirical studies of preference programs include Marion (2007, 2009) who finds two specific preference
programs to be costly to governments; Denes (1997) who provides evidence of cost decreases in some set-aside
auctions for dredging work; and Ayres and Cramton (1996) who argue that preference programs yielded significant
revenue increases in a small sample of FCC spectrum auctions. These papers use descriptive methods, which
allow them to measure the effects of the current programs, but do not permit an evaluation of alternative
program designs. Decarolis (2009) analyzes average price auctions that could be interpreted as an extreme form
of preference policy where the bid closest to the average wins and the high bid is eliminated.
1
an auction. We show that accounting for a response in participation behavior significantly
alters the assessment of the preference program’s cost to the government and its distributional
effects. While it continues to be possible to use bid discounts to lower the cost of procurement
as in McAfee and McMillan (1989), both the cost-minimizing level of the discount and the
group receiving the discount may change when participation effects are taken into account. The
currently accepted practice of evaluating bid preference programs holding participation fixed can
yield very misleading results.
The theoretical literature suggests that the magnitudes of the program’s effects crucially
depend on the degree of cost asymmetries between favored and other bidders. We thus base
our analysis on empirically relevant distributions of firm costs recovered from data on highway
procurement auctions that were awarded under a bid preference program. We use a model of
firms’ participation and bidding decisions in the presence of a bid discount.
5
The firm’s decision
of which bid to submit reflects its private information about its cost of completing the project,
which we term “project cost”, and the distributions of its competitors’ project costs. The
participation decision instead is based on a comparison of the cost of preparing the bid, or entry
cost, to the expected profit from participation. Only firms with entry costs below the expected
profit ultimately submit a bid in the auction. We use this model to uncover the underlying
distributions of firms’ entry and project costs consistent with observed choices.
The nature and importance of our findings can be seen from Figure 1 that plots changes
in the government’s cost of procurement relative to no discrimination at different levels of the
bid discount for a typical project in our data.
6
We contrast the cost of procurement implied by a
model that does not allow firms to respond to the discount in their participation behavior with
one where participation adjusts endogenously. Several patterns emerge:
1. Under fixed participation, the cost of procurement varies only by a limited amount as the
discount changes from 50% to large bidders (the leftmost point in the figure) to 50% to
small bidders (the rightmost point). The cost of procurement exhibits significantly more
variation when we take participation effects into account.
2. The implications for policy design differ significantly in the two cases. To minimize the cost
of procurement, the model with fixed participation prescribes a discount of approximately
15% to small bidders. Relaxing the assumption of fixed participation suggests that offering
such a discount to small bidders would actually increase the cost of procurement. Instead,
a discount of 50% should be offered to large bidders to achieve substantial cost savings.
3. California’s Small Business Preference program aims to allocate 25% of procurement dollars
5
Our analysis also contributes to a small, but growing literature that empirically studies the decision to
participate in auctions. Athey, Levin and Seira (2008), Bajari and Hortacsu (2003), Li (2005), and Li and Zheng
(2009) represent recent contributions to this literature.
6
The project’s cost distributions are representative of approximately 30% of projects. The remaining projects
are discussed in the main body of the paper.
2
to small firms, which we refer to as the program’s “allocative goal”. The fixed participa-
tion model implies that the small-firm discount required to achieve this goal is equal to
50% for this particular project. This model predicts that such a discount yields a 0.6%
increase in procurement cost. However, a model that takes participation adjustments into
account would recognize that this substantial discount deters large-firm participation and,
therefore, that the true cost increase would be 7%. Additionally, preferential treatment
increases small-firm participation and in turn the group’s probability of winning, hence, a
bid discount of only approximately 20% is sufficient to achieve the allocative goal, raising
the government’s cost by 2%.
Figure 1: Cost of Procurement and Probability of Winning under Fixed and Endogenous Par-
ticipation, Sample Project
0.5 0.4 0.3 0.2 0.1 0 0.1 0.2 0.3 0.4 0.5
−0.02
−0.01
0
0.01
0.02
0.03
0.04
0.05
0.06
0.07
N
small
=2, N
large
=3.
Proportional Change in Cost relative to No−Discount Level
Endogenous participation
Fixed participation
Bid discount
to large firms
Bid discount
to small firms
0.5 0.4 0.3 0.2 0.1 0 0.1 0.2 0.3 0.4 0.5
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
N
small
=2, N
large
=3.
Small−Firm Probability of Winning
Endogenous participation
Fixed participation
Bid discount
to large firms
Bid discount
to small firms
Bid discount
to large firms
Bid discount
to small firms
Bid discount
to large firms
Bid discount
to small firms
Cost of procurement Small firms’ probability of winning
This example is based on a particular, albeit common, type of project in our data. An
aggregate evaluation of California’s preference policy needs to take into account heterogeneity
in project characteristics and the competitive environment, which introduces heterogeneity in
the effectiveness of a bid discount across projects. Our empirical results suggest significant
differences in the degree of cost asymmetries between large and small firms across projects. For
an important subset of projects in our data, we recover cost distributions for large and small firms
that are very similar. As a result, small-firm participation and winning rates for these projects
are high even in the absence of a bid discount. Because of the particular mix of projects, the
aggregate cost of procurement at a discount level that awards 25% of procurement dollars to
small firms is only 1.2% higher than the aggregate cost under no preferential treatment. It is
important to note, however, that this result is specific to the California market. In other markets
where the composition of projects is different, the cost of bid preference programs may be very
different.
For California’s current program, which uses a relatively low discount level of 5%, we
3
find that the cost of procurement is within 1% of the cost of procurement in the absence of
discrimination. However, the program induces substantial changes in small and large firms’
participation and probabilities of winning. It results in a redistribution of 10 to 18% of profits
from large to small firms for typical projects that differ in type of work, location, and size. At
the same time the program does not achieve its goal of allocating 25% of procurement dollars to
small firms.
Interestingly, we find that an alternative preference mechanism that relies on lump-sum
entry subsidies and/or taxes is more cost effective than a discount program. An appropriately
chosen entry tax, for example, lowers the cost to the government significantly more than the
cost-minimizing bid discount by extracting bidders’ full expected surplus. Such a tax does not,
however, achieve the State’s allocative goal. We show instead that a combination of a subsidy
to small firms and a modest tax on large firms can be used to satisfy California’s allocative goal
at important cost savings relative to a bid discount and equivalent award levels. An entry tax or
subsidy, by affecting firms’ participation margins regardless of their ultimate cost of completing
the project, avoids a distortion associated with bid discounts that grant higher absolute gains
to bidders with high cost draws. It is through this channel that lower costs of procurement can
be realized.
The paper proceeds as follows. Section 2 provides a brief overview of the highway pro-
curement market in California and the details of the Small Business Preference program. Section
3 outlines the model of firms’ joint participation and bidding decisions. Section 4 describes our
estimation methodology, the results of which are in Section 5. Section 6 contains an analysis of
the current and alternative programs. Section 7 concludes.
2 California’s Highway Procurement Market
In this section, we describe the California highway procurement market and our data. We focus
on highway and street maintenance projects auctioned by the California Department of Trans-
portation (‘Caltrans’) between January 2002 and December 2005. California’s Small Business
Preference program is implemented on state-funded projects. During the sample period, Caltrans
advertised 869 state-funded projects, of which complete data are available for 697 projects.
7
The
data include information on project characteristics, the set of companies that purchased detailed
project specifications and their small business status, the set of actual bidders, their bids, and
finally, the identity of the winning bidder.
Letting Process. Caltrans advertises projects three to ten weeks prior to the bidding
date. The project advertisement usually contains only limited information, such as type of work,
location, and completion time. Interested contractors must purchase detailed project plans from
7
Caltrans did not preserve lists of companies that purchased bid documents for some projects.
4
