Auctions and Auction Markets

Chapter 25: Auctions and Auction 1

Markets
 Introduction
• Auctions have an old history and are increasingly
common
– 193 AD, Praetorian Guard auctioned off the the
Roman Empire to Marcus Didius Salvius
Julianus
– Modern Examples
• eBay (Consumers)
• Covisint/Free Markets (B2B)
• Wireless Spectrum Auction (Government2B)

Chapter 25: Auctions and Auction 2

Markets
 Auction Types
Ascending Bid or English Auction
– Probably most familiar—Price starts low
– Price is raised gradually until only one bidder remain
Descending Bid or Dutch
– Price starts high
– Price is lowered until someone finally wants to buy
Sealed Bid Auctions
– Bids effectively submitted in sealed envelopes
• First-Price Sealed Bid: Winning bidder pays amount bid
• Second-Price Sealed Bid: Winning bidder pays amount equal to
second-highest bid
Private Value Auction—Item value different for each bidder
Common Value Auction—Item value common to all bidders but
each has different information about true common value
Chapter 25: Auctions and Auction 3
Markets
 The Revenue Equivalence Theorem
Revenue to Seller is Same Regardless of Auction Type in a
Private Value Auction
• Consider auction of textbook among 170 students
• Values start at $0.50 and increase by $0.50 with each
student. So, top value is $85
– Consider English Auction where Auctioneer raises price by 1¢
each round
• When bid reaches $84.50, only two bidders remain
• Final winning bid will be $84.51 when only one bidder is left
– Second Price Sealed Bid
• If bidders bid their true values, top two bidders will bid $85 and
$84.50, respectively
• Bidder with $85 valuation will win but pays only $84.50  $84.51

Chapter 25: Auctions and Auction 4

Markets
 Revenue Equivalence (Cont.)
• Why bid one’s true value in Second-price, sealed
bid auction?
– What one bids determines only if one wins—not what
one pays
• Bidding less than true value risks losing the object to someone
who values it less than one is willing to pay without changing
the price
• Bidding more than true value raises chance of winning but
only by beating out a bidder with a higher value than your own
• You will then pay that higher value and, since it exceeds your
own, lose out

Chapter 25: Auctions and Auction 5

Markets
 Revenue Equivalence (Cont.)
• Winning Bid in a First-Price, sealed bid auction
– bidders observe no other information about other bidder’s value
prior to making a bid
– Winner pays the winning bid
– Suggested Strategy: Bid an amount equal to one’s best guess of
next highest bid
• Treat your value as the highest (if it’s not, winning is too costly)
• If valuations are uniform, next highest is (N –1)/N of your value
• E.g., bidder with value $85, bids (N –1)/N *$85 = $84.50, N = 170
– Here again, winning bid is $84.50
– This is a general result and important. We don’t want an object’s
value to depend on how it was bought

Chapter 25: Auctions and Auction 6

Markets
 Revenue Equivalence (Cont.)
• Dutch or descending price auction is strategically identical
to first-price, sealed bid auction. Again, in both:
– bidders observe no other information about other bidder’s value
prior to making a bid
– Winner pays the winning bid
– Optimal strategy should be the same in both
– So, winning bid will again be $84.50
Revenue Equivalence: Regardless of auction type, the
winning bid or payment is always $84.50
– This is a quite general result. In private value auctions, the revenue
to the seller is the same regardless of what type of auction is held
–It is good that Revenue Equivalence holds. We do not want an
object’s price to depend on how it is bought

Chapter 25: Auctions and Auction 7

Markets
 Common Value Auctions
In common value auctions, item has an unknown but
common market value, e.g., real estate
• Bidders have different information about the true value
• That true value depends on what others are willing to pay
• Revenue Equivalence may not hold
The “Winner’s Curse” in Common Value Auctions
• Winner of a common value auction is one with highest
estimate of true common value, e.g., highest estimate of
the value of a property
• Winning can be bad news. It reveals that the winner’s
information was most upward biased and bid was higher
than the average or expectation of the true value

Chapter 25: Auctions and Auction 8

Markets
 Common Value Auctions (cont.)
• Minimizing the Winner’s Curse
– To avoid the winner’s curse, bidders need to shade their bids below
that indicated by their information
– This requires recognizing that one is interested in the object’s true
value if one wins the bid, i.e., if one wins, that says something
about the object’s true value
– Need somehow to use this information to estimate the average or
expected mean value of the property
• Again, assume that your estimate E is the highest (you’re not interested
in the object’s value if it is not)
• If there are N bidders and the distribution is uniform, then highest
value of E is on average, U(N-1)/N where U is the upper limit of the
distribution.
• Solving for U yields: U = [N/(N-1)]E  Average Estimate is
[N/2(N-1)]E . This is the amount to bid. It is well below E which is
why it helps one minimize the winner’s curse.

Chapter 25: Auctions and Auction 9

Markets
 Common Value Auctions (cont.)
• For example, if there are 100 bidders each drawing
estimates of a property’s value such that those estimates are
uniformly distributed; and if my estimate is $10,000
– My best guess is that the uniform distribution ranges from 0 to [100/
(100-1)]$10,000 or from 0 to $10,101
– My guess for the average value of the estimates is therefore
$5,050.50
– I bid much less than the estimated property value in an effort to
avoid the winner’s curse of paying too much
• With Common Value auctions, all auction types may not
generate the same revenue—
• Ascending price auctions, for example, reveal more
information than other types about the estimates of other
bidders—Revenue Equivalence can break down
Chapter 25: Auctions and Auction 10
Markets
 Almost Common Value Auctions
• Some auctions are a mix of private and common valuations
– “Almost common value auctions” are those in which the object has
a common value to nearly all bidders but one who values the object
by some amount, v, above everyone else
– Surprisingly, even when v is small, the effect on revenue can be
large. Why? Because the winner’s curse cuts doubly in this setting
• Example: 5 local coffee shops and Starbuck’s all bid for a coffee store
• Whatever the store is worth to the locals, it’s worth more to Starbuck’s
• As a result, each local bidder faces an intensified winner’s curse
• To win the bid, it must beat Starbuck’s bid which is biased upwards
• This means that its estimate must really be unusually high
• Accordingly, local bidders shade their bids even more
• But this allows Starbuck’s to be more aggressive, causing locals to
shade their bids even more
• Starbuck’s will win the bidding but at a much reduced price

Chapter 25: Auctions and Auction 11

Markets
 Auction Markets and Industrial Organization
• Auction markets are affected by the problems of monopoly
and collusion that affect other markets
• Auction design can be helpful in this regard
– Ascending auction can limit winner’s curse effects but:
• Facilitates collusion
• Facilitates communication of asymmetric values
– On both counts, the English auction may result in lower revenue
• Sealed bid designs works well
– It encourages entry because there is a chance of winning even if a
firm’s estimated value is not the highest
– It reduces collusion opportunities
• However, there can be too many bidders. Winner’s Curse
rises with the number of bidders. The price-raising effect
of more bidders may be offset by the price-shading effect.
Chapter 25: Auctions and Auction 12
Markets