Asymmetric Information and Collusive Behavior in Auction Markets

Abstract

We present a theoretical and empirical analysis of the behavior of a bidder's cartel in a multiperiod auction market in which the purchaser is relatively uninformed. Our work establishes a tentative connection between the economics of information and collusion by concentrating on the cartel's informational monopoly, and its ability to both increase profits and mask its presence by passing misinformation to the purchaser. In the models we develop, costs are assumed to be stochastic, and projects awarded in adjacent periods to be substitutes for one another. As a result, the purchaser will have incentive to intertemporally reallocate his demand, buying more or less of the current period's project, depending upon whether the current market price is lower or higher than the price which he expects to prevail in the future. A purchaser who needs to form such price expectations, yet is ignorant about production costs and market structure, will be particularly attracted to the auction mechanism, because the data contained in past auctions' bids can apparently be incorporated into an explicit structural model of expected future price. In fact, such a purchaser may hold auctions frequently merely to acquire information. Such pleasant appearances are deceiving. Once the auction's bidders become aware of the informational use to which their bids are being put, they will have incentive to form a cartel, thereby extracting a premium for their knowledge by misinforming the purchaser and skewing his intertemporal decision making to their advantage. In some respects the mechanics of our model resemble the case of a multiproduct monopolist selling goods that are substitutes for one another. What is unique to our analysis is the dependence of one of the goods, future demand, on price expectations, which are an information resource. We are suggesting that information that is distributed asymmetrically among market participants is susceptible to the inefficiencies of collusion. In some ways the implications of our work are considerably stronger than this, because our cartel never reveals its true knowledge, and thus our market may be more inefficient than more standard monopolies, in which the good is always traded, albeit at noncompetitive prices. Furthermore, by explicitly modeling the purchaser's rational structural approach to price forecasting, we point out that complete rational expectations models may be more susceptible to exploitation by informational cartels than simpler forecasting techniques. We have tested the implications of our model in a case study of North Carolina highway construction cartels. The highway construction industry is an auction market characterized by government procurement agencies who are uninformed relative to suppliers, and comes complete with a substantial record of known collusion in recent years. Thus it seems an ideal hunting ground for verification of our theoretical findings. Our paper proceeds as follows. In Section I, we model a multiperiod competitive auction market, and describe a Bayesian mechanism through which the purchaser uses past data to improve the accuracy of his price expectations. Section II establishes theoretical results for the bidders' cartel which has incentive to form in this market: we describe *Massachusetts Institute of Technology, Cambridge, MA 02109 and University of Arizona, Tucson, AZ 85721, respectively. Nold was formerly of Rhodes Associates and is now deceased. We thank Richard Schmalensee and the participants of the Economic and Legal Organization Workshop at the University of Chicago for valuable suggestions. Part of this research was supported under research grant 81-IJ-CR0062 from the National Institute of Justice.

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