Managerial economics 3rd by froeb ch18

11

Chapter 18:
Auctions
1

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Summary of main points
• In oral or English auctions, the highest bidder
wins by outbidding the second- highest bidder.
This means that the second-highest bidders’
value determines the price.
• A Vickrey or second-price auction is a sealed-bid
auction in which the high bidder wins but pays
only the second-highest bid. These auctions are
equivalent to oral auctions and are well suited for
use on the Internet.
• In a sealed-bid first-price auction, the high bidder
wins and pays his value. Bidders must balance
the benefits of bidding higher (a higher
probability of winning) against the costs of
bidding higher (reduced margin if they do win).
Optimal bids are less than bidders’ private values.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Summary of main points
(cont.)

• Bidders can increase their profit by agreeing
not to bid against one another. Such collusion
or bid rigging is more likely to occur in open
auctions and in small, frequent auctions. If
collusion is suspected,
• do not hold open auctions;
• do not hold small and frequent auctions;
• do not disclose information to bidders—do not
announce who the winners are, who else may be
bidding, or what the winning bids were.

• In a common-value auction, bidders bid
below their estimates to avoid the winner’s
curse. Oral auctions return higher prices in
common-value auctions because they release
more information than sealed-bid auctions.
Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Introductory anecdote: Bell
Telephone
• In 1885, Bell Telephone Company of Canada
established Northern Electric to manufacture
its telephone equipment.
• By 2000, the company (now Nortel) had a market
share of over $200 Billion
• Decade of bad investments, declared bankruptcy
in 2011

• Nortel approved for sale by bankruptcy court

• The court was unsure of the value of some of the

company’s assets, such as the 6000 patents, and
decided to sell these assets with an auction.
• The bidding started at $900 million but was
pushed up to $4.5 billion after successive rounds
of bidding.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Introduction: Auctions
• Auctions are simply another form of competition,
like price competition or bargaining.
• CarBargains is one company that uses auctions
to help car buyers.
• In these auctions, though, sellers not buyers are
competing.
• Local car dealers offer prices to a single consumer in
a sealed-bid auction.

• Auctions set a price and identify the high-value
buyer or low-cost seller.
• Auctions are often used in combination with
bargaining, e.g., first an auction is used to
identify the high-value buyers and then there is
a negotiation over the final price.
Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Oral Auctions
• Definition: In an oral or English auction, bidders
submit increasing bids until only one bidder remains.
The item is awarded to this last remaining bidder.
• Example: Suppose there are five bidders with values
equal to {$5, $4, $3, $2, $1}.

• The $5 bidder will win the auction, and bids only
slightly over $4 to do so.

• The “price” or winning bid is $4, or slightly above.
• The winning bidder is willing to pay $5 but doesn’t

have to, so the losing bidders determine the price in
oral auctions.

• Auctions identify the high-value bidder (“efficiency”)
and set a price for an item, with no negotiating
necessary. For these reasons, economists love
auctions.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Benefits of auctions
• Example: auction vs. posted-price

• A retail store is unsure whether they should price
high ($8) or low ($5) for a certain item.
• If the store prices high, they sell to only high-value

buyers (half the time). If the store prices low, they
sell to all customers at a lower price.
• If MC = $3, then pricing high is preferable
(.5)($8-$3) = $2.50
[versus (1.0)($5-$3) = $2.00]
• If the store uses an auction instead, and two bidders
show up with values $8 and $5 – meaning there is
again a .5 chance of selling to a high-value costumer
– what will the revenue of the sale be?
Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Oral Auctions (cont.)

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Second-Price Auctions
• Definition: A Vickrey or second-price auction
is a sealed-bid auction in which the item is
awarded to the highest bidder, but the winner
pays only the second-highest bid.

• This at first seems counterintuitive – why leave
money on the table? But second-price auctions
encourage bidders to bid more aggressively.

• William Vickrey and James A. Mirrlees shared the
1996 Nobel Prize in Economics for their work
inventing the Vickrey auction and establishing

that there is no difference in outcome between
an oral and second-price auction.
Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Second-price auctions
(cont.)
• Because the winning bidder pays the price of the
second-highest bid, bidders are willing to bid up to
their values, so the outcome is the same as an oral
auction.

• Second-price auctions are easier to run than oral
auctions because the bidders can bid in remotely,
and asychronously (at different places and times).
• Discussion: Why are eBay auctions equivalent to
second-price auctions?
• Discussion: Why does eBay use second-price
auctions?

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Sealed-Bid Auctions
• Definition: In a sealed-bid first-price auction, the
highest bidder gets the item at a price equal to the
highest bid.
• These auctions present a difficult trade-off for bidders:

• A higher bid reduces the profit if you win, but

• Also raises probability of winning
• Bidders balance these two effects by bidding below
their values (“shading”).
• Experience and knowing the competing bidders are
the keys to these auctions, but in general, bid more
aggressively – shade less – if the competition is strong.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Bid Rigging or Collusion
• Example: an oral auction with bidder values of
{$5, $4, $3, $2, $1}.
• Suppose that in this auction the two high-value
bidders have formed a bidding ring (also known
as a cartel).
• The two decide NOT to bid against each other, so
the cartel wins the item by outbidding the noncartel members, i.e., price= $3. The cartel makes
a profit of $1 which typically is split evenly
between members.

• Bid-rigging is a criminal violation of antitrust
laws in the US and many other countries.
• In one type of bid-rigging, cartel members reauction the items won in a second-auction to
cartel members in a second or “knockout”
auction.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Bid-rigging / Collusion (cont.)
• Another type of collusion is known as a bidrotation scheme. This scheme uses quid pro
quo bidding behavior.
• Bidders in these cartels submit weak bids or
refrain from bidding against each other until it
is their turn to “win.”
• In a bid-rotation scheme each cartel member
must wait for his turn to win – a weakness that
leaves these schemes vulnerable to cheating.
• Proposition: Collusion is more likely in oral
auctions.
• Proposition: Collusion is more likely in small,
frequent auctions.
Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Bid-rigging: Frozen Fish
Conspiracy

• After this cartel was broken the price of fish dropped 23%
• Investigators backcast from the competition period into
the collusive period to determine the cartel’s effect, i.e.,
what the price would have been, “but for” the conspiracy.
Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Reacting to bid-rigging
• The government is frequently the victim of bidrigging schemes.
• Learning from the government’s experience,
some tips to avoid collusion:

• Do not rely on purchasing agents (those running
the auction) who have little interest in buying at a
low price. Instead, reward agents for making good
(high-quality and low-price) purchases.
• Do not entangle purchasing agents with masses of
red tape. Instead, permit them to negotiate (e.g.,
to bargain with the bidders) if they suspect bid
rigging.
•

But beware of patronage

• Do not use the procurement process to further a

social agenda (small business set-asides, public
lands, national defense, etc.) that is irrelevant to
the goal of purchasing goods at low prices.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Avoiding collusion (cont.)
• Keep cartels in the dark, so it is difficult for them to
organize and to punish cheaters.
•
•
•

do not hold open auctions;
do not hold small and frequent auctions;

do not disclose information to bidders—do not
announce who the other bidders are, who the winners
are, or what the winning bids are.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Common-Value Auctions
• Definition: In a common-value auction, the
value is the same for each bidder, but no one
knows what it is. Each bidder has only an
estimate of the value.
• Be careful in these auctions lest you suffer the
“winner’s curse”
• If you win, you learn that you were the one
who had the highest and most optimistic
estimate of the unknown value of the item
•

Bidders should reduce their value estimates to
protect against this.

• If you are the auctioneer, release info to
mitigate winners’ curse.
• Winner’s curse is worse when
•
•

More bidders
Other bidders have better information

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Common-Value Auctions
(cont.)
• To avoid the winner’s curse bid less aggressively
as the number of bidders increases.
• In common-value settings, oral auctions return
higher prices than sealed-bid auctions because
oral bids reveal information.

• But oral auctions are more vulnerable to collusion.
• Discussion: Why do bidders wait until the last
minute of the auction to submit bids on eBay?

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.