Preferred Suppliers and Vertical Integration in Auction Market

We consider a model of preference in an asymmetric procurement auction with two suppliers. The buyer can award the contract to a preferred supplier at the bid of a competing supplier. As such, the preferred supplier has a right-of-first-refusal. The preferred supplier may be an independent firm who has paid for the preference or may be a subsidiary of the buyer. Preference creates an allocative distortion that is qualitatively different than the distortion that arises in an asymmetric first-price auction. For a family of power distributions on the costs, we examine the effects of preference on the expected price paid by the buyer. If the buyer is not compensated for the preference, the expected price in the preference auction will be higher than either an efficient auction or a first-price auction. However, if the buyer can sell preference in a pre-auction, the net expected price will always be lower than an efficient auction, or even the first-price auction. The stronger supplier with the more favorable cost distribution has a greater willingness to pay for preference, and will outbid the weaker supplier to acquire the preference in the pre-auction. Similarly, the buyer can lower the net expected price by acquiring the stronger supplier as a preferred subsidiary.