The impact of transaction costs and competitiveness on the performance of reverse auctions
Date
2018
Authors
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Journal ISSN
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Publisher
University of Delaware
Abstract
Voluntary agri-environmental programs are used to enhance ecosystem services in agricultural landscapes. Through these programs, agricultural landowners and producers voluntarily enter into payment for environmental services (PES) contracts by agreeing to adopt agricultural best management practices (BMPs) in exchange for financial incentives. Reverse auctions have been touted as being a cost-effective way to allocate scarce PES funds. Existing literature suggests that adequate participation in an auction is critical to making the reverse auction mechanism cost-effective. Participation in a reverse auction can require substantial effort and time from participants – these costs of participation are referred to as transaction costs. High transaction costs can reduce the cost-effectiveness of reverse auctions by limiting participation and thus reducing the number of bids submitted, particularly if farmers believe that the chance of their bid being accepted is low. Although transaction costs have been incorporated in recent experimental reverse auctions, few studies have formally analyzed how such costs affect the performance of reverse auctions. ☐ Using an economic laboratory experiment, this study tested the impacts of transaction costs on the participation rate and the overall cost-effectiveness of reverse auctions. I used a 3x2 within-subject experimental design to conduct a laboratory experiment that tested the impact of three levels of transaction costs (none, low, and high) on auction performance under different budget constraints (low and high). Subjects (n=120) participated in multiple one-shot reverse auctions in which they submitted bids for the amount of money that they required to complete costly projects. Bids were ranked from lowest to highest by the cost per unit of benefit (i.e., project value) provided to the auctioneer, and bids were accepted in order until the budget was exhausted. My experiment had six sessions, and each session consisted of 36 rounds of bidding with six rounds per treatment cell. Each round was an independent auction and outcomes of one round did not affect the outcomes of another. ☐ The experimental data were used to test three hypotheses: (1) transaction costs reduce auction participation, (2) transaction costs reduce auction cost-effectiveness, and (3) transaction costs reduce participation and cost-effectiveness to a greater extent when the competitiveness of the reverse auction is higher. Experimental results suggest that changes in participation and not changes in bid levels reduce the level of environmental benefits procured with a given budget when high transaction costs are imposed. Additionally, the effect is greater when the auction is more competitive, and bidders expect the probability of bid acceptance is low. This research sheds light on the role of transaction costs in reverse auctions that are used to allocate PES funding.