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Rational under-pricing in bidding strategy: a real options model

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  • C. Y. Yiu
  • C. S. Tam

Abstract

Under-pricing in construction tenders is a common phenomenon and is commonly explained by the need of cash flows and penetration strategy. However, these explanations involve profit cutting and therefore are not plausible in explaining a long-term persistent phenomenon of under-pricing. A real options model is proposed and using the binomial lattice method a real-life construction project tender was analysed to examine how management flexibility and uncertainty provide real options value. When uncertainties of cost items in a tender exist and choices are available to defer and switch modes of construction, then a valuable option is available to the bidders. It amounts to about 4% of the lump sum tendered in our case. The under-priced portion is the options value which the bidder is willing to pay for the flexibility and the uncertainty. These findings enable contractors to be more competitive and to estimate construction costs more accurately in devising their bid strategies.

Suggested Citation

  • C. Y. Yiu & C. S. Tam, 2006. "Rational under-pricing in bidding strategy: a real options model," Construction Management and Economics, Taylor & Francis Journals, vol. 24(5), pages 475-484.
    • Handle: RePEc:taf:conmgt:v:24:y:2006:i:5:p:475-484
    DOI: 10.1080/01446190600601560
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    References listed on IDEAS

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    Cited by:

    1. João Adelino Ribeiro & Paulo Jorge Pereira & Elísio Brandão, 2013. "Volume Uncertainty in Construction Projects: a Real Options Approach," CEF.UP Working Papers 1309, Universidade do Porto, Faculdade de Economia do Porto.
    2. Author-Name: Luca Di Corato & Cesare Dosi & Michele Moretto, 2014. "Bidding for Conservation Contracts," Working Papers 2014.65, Fondazione Eni Enrico Mattei.
    3. Di Corato, Luca & Dosi, Cesare & Moretto, Michele, 2018. "Multidimensional auctions for long-term procurement contracts with early-exit options: The case of conservation contracts," European Journal of Operational Research, Elsevier, vol. 267(1), pages 368-380.
    4. João Adelino Ribeiro & Paulo Jorge Pereira & Elisio Moreira Brandão, 2020. "A real options approach to optimal bidding in construction projects considering volume uncertainty," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 41(4), pages 631-640, June.
    5. Chiara D’Alpaos & Michele Moretto & Paola Valbonesi & Sergio Vergalli, 2013. "Time overruns as opportunistic behavior in public procurement," Journal of Economics, Springer, vol. 110(1), pages 25-43, September.
    6. João Adelino Ribeiro & Paulo Jorge Pereira & Elísio Brandão, 2012. "Reaching an Optimal Mark-Up Bid through the Valuation of the Option to Sign the Contract by the Successful Bidder," CEF.UP Working Papers 1201, Universidade do Porto, Faculdade de Economia do Porto.

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