The Winner’s Curse And How To Solve It

The winner’s curse comes out of economic theory, but is very relevant to any project manager outsourcing work to vendors.

Essentially if you are bidding out work where:

1. The costs are uncertain
2. You are going to pick the lowest bidder

Then there’s a good chance the vendor you pick won’t make any money out of the contract. This is because if the cost of the work is uncertain, all vendors are essentially guessing at the cost, and that’s fine. The problem is that in picking the cheapest vendor you are choosing the one who’s guessed lowest. However, based on the wisdom of crowds the most likely actual cost of the work is the average of all the bids you’ve received, but you’re not paying the average, you’re paying the lowest and the problem there is that the vendor is likely to lose money (the difference between the average of all bids and their bid),

Now, on the face of it that might sound like a good thing, but in practice, if you look at the delays that results on the Wembley Stadium project and Scottish Parliament project look can see that having a vendor who’s not making money working for you can cause problems for the overall project. It’s important to note that this outcome is a result of the structure of the bidding process, and is not because anyone is necessarily trying to rig the bidding.

So, how can this be solved, here are a few ideas (and thanks to the audience at a presentation I gave in Vancouver last year for helping out with these)

1. Declare in advance you will pick the second lowest bidder. This removes the incentive to come as the lowest and win the bid.

2. Ask for a detailed proposal, not just a price. Read the detailed proposals first, pick the best, then look at the price and see if your budget can cover it. If not, either move to the next best proposal, or ask for more funding.

Book Review – The Dead Hand

The Dead Hand is a wonderful historical narrative of the weapons of the Cold War and the negotiations to limit them. The term Dead Hand comes from the Soviet system to potentially automatically launch nuclear weapons in the event of attack. The book covers biological, nuclear and chemical weapons and is most interesting aspect is peeling back the layers of the Cold War negotiations, especially between Reagan and Gorbachev, demonstrating each sides’ perception of the other and what the reality was. The result is very interesting, showing how hard it is to read a negotiating partner accurately and how your own side’s actions and perspectives inevitably color your judgment. Recommended for anyone with an interest in recent history, though learning more about these weapons will likely result in you feeling worse rather than better about them.