Governments at all levels have successfully used auctions to procure goods and services. Furthermore, governments often let bidders subcontract portions of a project, even with companies that are competing with them on a bid. Little work has been done to explore the linkage of subcontracting and the bidding behavior of firms submitting sealed bids for projects awarded to the lowest bidder. Most obviously, exchanging subcontracting price signals ex ante presents bidders with an opportunity for tacit collusion. This dissertation explicitly models such an exchange of subcontracting price signals and the subsequent bidding behavior of two firms competing in a first-price auction.; The research focuses on three problems. First, the model assumes both firms have identically and uniformly distributed costs but have different relative efficiencies in producing components of the project up for bid. Under these circumstances, it is proven that an equilibrium exists in which each firm signals the highest possible subcontracting price for the component it produces efficiently and then bids only if its realized cost is below a threshold level. Interestingly, that bid is never less than the government's reserve price. Second, it is possible to determine the government's optimal reserve price for the project and its best mechanism. It can be shown that the best mechanism for the government, acting in its role as social planner, is the one that allows ex ante signaling. This also guarantees production efficiency. This surprising result is that a less "competitive" mechanism performs the best. Third, the model is modified so that subcontracting occurs after bidding with the losing bidder making a take-it-or-leave-it offer to the winning bidder to subcontract for a portion of the project. This has the same solution as the mechanism that permits ex ante signaling. This research has ramifications for improving mechanism design of diverse activities such as public universities procuring services from outside private vendors, state and local governments procuring goods and services from the market, or the Department of Defense contracting for services with private companies.
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