Estimation in a Competitive Context

I’m debating an issue with Steve McConnell, over on his blog, and I’d like to hear what others think of the issue.

I have a theory that, when multiple suppliers are competing for the same contracts, market forces encourage selection of those suppliers who have under estimated (either knowingly or unknowingly).  It’s some kind of “reverse natural selection”, where the market tends to select the least fit proposals (those that are most underestimated).

“…market forces systematically bias the winning bid [towards under-estimation], even when the set of all bids is not biased at all…”

[Update March 2009:  I have found the name for this phenomenon.  It is an effect well known to economics, and first mentioned over 200 years ago!  It’s called the Winner’s Curse.  Very little has been written about it in software, although I did find some very good research papers from the Simula Research Lab in Norway.  They’re well worth reading.  As Jørgensen and Grimstad write, the winner’s curse can easily become the customer’s curse – so it is the interests of both parties to minimise it’s effects!]

 

Steve McConnell and I discuss this at some length on his blog. He suggests that, while my logic is interesting, it cannot possibly be true — because if it was true all such suppliers would go out of business.  My reply is that my logic is still correct; they do struggle on projects with early fixed prices, but they stay afloat on revenue from other sources:

  • One source is change requests and follow-on projects, which I believe can (and should) be done more ethically than this all-too-common-common model.
  • Another source is competitive projects won by more realistic means.  Steve mentions things like two-phase contracts and delaying final fixing of price until later in the cone of uncertainly.   Ayende advocates competing on quality rather than price. I completely agree, and advocate some of the same ideas here and here.
  • The final source is projects which simply never went through a competitive bid process.  There are many reasons why some projects do not go through competitive bid processes.  Such projects are a perfect opportunity for the customer to choose a supplier who they already know and like.

I believe that these three sources help to sustain many outsourcing companies.  If not for these three sources, things might get ugly.  I wrote:

“…selecting the lowest bid has been blamed for creating unsustainable markets in traditional (construction) engineering…

To me, the experience of the construction industry offers some indication that price-based selection can indeed skew the winning bids downwards, to the detriment of an entire industry.  If it is documented in traditional construction, perhaps it possible in IT too.  Perhaps it hurts all outsourcers…”

What do you think?  When prices must be fixed early, does a price-sensitive market make it “impossible” to win profitable work?

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