Self-Made Competition Barriers in Procurement – and how game theory dissolves them

As a rule of thumb: every rigid rule that procurement sets for itself is a potential barrier to competition. Rigid rules impose a framework on the market within which it has to optimize – and at the same time deprive it of the chance to help shape the optimal conditions itself. This can lead to efficiency losses.

A typical example is sourcing strategies fixed a priori. An organization decides, say, that strategic materials must under no circumstances be procured from a single source, and ideally in similarly large volume shares per supplier. From a risk-management perspective this is understandable: if one supplier fails, production keeps running. From a negotiation-theory standpoint, too, maintaining permanent competition within a category can make sense – at least at first glance.

A second look through the game-theoretic lens, however, raises questions: how much cheaper would a single supplier have been? What economies of scale would a maximally large package have generated? What dynamics would have arisen if one supplier had come away empty-handed? What does the failure of the sole supplier actually cost – and could that risk be shifted in some other way?

Framed sensibly, these questions describe a trade-off between risk minimization and cost. The difference lies in how you resolve it. The classical approach first fixes the risk (for example via a dual-source requirement) and only then optimizes cost within that framework. Game theorists resolve it simultaneously: they leave the trade-off where the most knowledge about price structures sits – in the market. Concretely, you could define a risk premium that a single-source solution has to save in order to be better overall than the lower-risk but more expensive dual-source solution. Both variants are negotiated in parallel; the market decides whether the more attractive bundling actually earns back the risk premium.

Important: a dual-source strategy is not necessarily a strong restriction on competition. If there are many suppliers, switching costs are low and the volume is high in relation, the competition-weakening effect stays small. But precisely for strategic categories with risk relevance, this comfortable constellation is rare. The prescribed number of suppliers illustrates how intelligent game-theoretic approaches produce solutions that are sometimes better, usually similarly good, but never worse than the rigid approach.

Supplier exclusion is the most obvious form of impeding competition. Often bidders fail to meet supposedly strict requirements – and are excluded. Implicitly, this assumes that the gap would be unacceptable even at a price of zero euros. If you ask explicitly whether you would accept the unmet requirements, or arrange things differently, in exchange for a 100% saving, the answers frequently turn out different. Of course no one offers at zero euros – but the thought experiment shows when a knock-out criterion could be replaced by a bonus-malus arrangement.

What matters here is not giving the challenger a theoretical chance. Game-theoretic analysis looks at the overall competitive dynamics: even a bidder with no realistic chance of winning can open up additional options in how the negotiation or the award mechanism is designed. The value of an additional supplier is therefore measured not solely by its immediate savings potential, but by its effect on the overall intensity of competition.

Fixed amortization rules work more subtly. Supplier switches incur costs – new partners have to be integrated into processes, systems have to be reconfigured. Some organizations assess these switching costs as a flat figure: a switch is only an option if the new supplier delivers a predetermined saving and the switch thereby amortizes. Switching costs undoubtedly belong in every sourcing decision – but they should be determined through an individual delta assessment, not via a rigid flat figure.

If that does not happen, a distortion of competition is likely. Suppliers of small volumes in particular are hard to displace, because a challenger would have to offer extremely low unit prices to clear the flat amortization threshold. The same effect occurs even with large quantities if the switch has to pay off not over the product's lifetime, but already within the first two to three years.

Directed buy: Many Tier-1 suppliers, especially in the automotive and aerospace industries, receive requirements from the OEMs regarding supplier selection. Particularly for safety-relevant parts, or for components that matter for branding toward the end customer, they cannot freely decide on their supplier base. Although alternatives exist, this creates a de facto monopoly situation. This barrier is not directly self-made – but procurement should deliberately work toward having to carry out as little directed buying as possible.

Unaligned cross-functions: In supplier management there is often a conflict of objectives between functions. Engineering and production value reliability and continuity with known suppliers, while procurement has to keep testing that same relationship for acceptable cost. When engineering and production visibly side with the incumbent or preferred suppliers, this considerably weakens procurement's negotiating position.

Preferences may certainly play a role in decision-making – the only decisive point is that they are objectively measurable and can thereby be expressed indirectly in a monetary value. Without this common language toward suppliers, in the best case nothing happens, as long as the suppliers correctly assess their competitive situation on their own. The more likely case: they adjust their expectations. The suppliers favored by the cross-cutting functions then feel safer than is conducive to a competition-oriented negotiation. How such situations can be prepared methodically is shown by our work on procurement negotiations.

Last-call options (LCO) are very popular with experienced suppliers – for good reason. An LCO gives a supplier the right, in a competitive negotiation, to win the award at the same price at which another bidder without this option would have won. For an LCO to be attractive, the buyer granting it must be credible – and as a rule only a single supplier receives it.

With an LCO, the supplier's strategic calculus changes fundamentally. Without further levers, it initially has no incentive left to lower its price. In practice this is exactly what you observe: bidders with a guaranteed LCO barely make any further price reductions before the final decision. Only when they are confronted with the award do extreme discounts suddenly become possible. Until then, the LCO holder sits back comfortably and waits to see what final price it is presented with.

A first-price negotiation with an LCO therefore resembles a second-price auction. However, if the LCO holder accepts the price previously accepted under reservation, the expected award price lies above the result of an English or Dutch auction. To offset this, the LCO would have to imply a price below the conditionally accepted price – ideally by the expected gap between the lowest and second-lowest reservation price. This gap is not known, but it can be approximated from the bids submitted earlier. Without this additional discount, an LCO leads to a worse result – so its benefit has to be greater than the deterioration in expected value.

This deterioration grows the fewer bidders are in the race. With a small number of bidders, an LCO should therefore only be agreed with the utmost caution. On top of that: in game-theoretic award procedures that rely on fixed rules and commitment, an LCO weakens precisely that commitment and costs transparency. A binding take-it offer can then only be made under reservation, and for the remaining bidders the principal's actions become harder to follow – which can undermine acceptance of the procedure.

An LCO should therefore only be granted in return for a substantial counter-advantage. How large must it be? A simple worked example: three bidders submit the prices P1 = 100, P2 = 105 and P3 = 92. If you estimate from these the expected gap between the lowest and second-lowest price and weight it by the probability that the LCO holder is in fact the cheapest (in the example around 50%), then for the expected-value loss alone you arrive at a required advantage of roughly 1.6% of the award volume. Adding in the harder-to-quantify procedural disadvantages, under these assumptions around 2% of the award volume would be required to compensate for an LCO.

The degree of competition in a category is not solely a property of the market – it is determined to a considerable extent on the demand side. Rigid sourcing rules, premature supplier exclusions, flat amortization thresholds, directed buying, unaligned cross-functions and carelessly granted last-call options all have one thing in common: they are self-made, and therefore fundamentally avoidable.

The shared way out is a change of perspective. Instead of rigidly fixing the trade-off between risk, cost and procedural certainty in advance, game-theoretic approaches resolve it where the most knowledge about price structures sits – in the market. The result is solutions that are sometimes better, usually similarly good, but never worse than the rule-bound approach.

These are exactly the principles competitio translates into practice – with over EUR 35 billion in negotiated volume across 16 industries, scientifically grounded by Prof. Dr. Christian Rieck on the advisory board. Want to find out where your procurement is unwittingly blocking competition for itself? Talk to us.