Auctions including English auction, First price sealed bid auction, second price sealed bid auction, Dutch auction, winners curse Kristin Westerfield Final Paper Prior to beginning a real world discussion of different types of auction and their resulting effect on buying and selling, it is important to understand a few key terms. According to Dr. Baye's book, Managerial Economics and Business Strategy, in an auction "potential buyers compete for the right to own a good, service, or, more generally, anything of value." In the coming weeks, I will discuss real-world applications of the following four types of auctions, as defined in Dr. Baye's book:
English auction - An ascending sequential-bid auction in which bidders observe the bids of others and decide whether or not to increase the bid. The auction ends when a single bidder remains; this bidder obtain the item and pays the auctioneer the amount of the bid.
First-price, sealed-bid auction - A simultaneous-move auction in which bidders simultaneously submit bids on pieces of paper. The auctioneer awards the item to the high bidder, who pays the amount bid.
Second-price, sealed-bid auction – A simultaneous-move auction in which bidders simultaneously submit bids. The auctioneer awards the item to the high bidder, who pays the amount bid by the second-highest bidder.
Dutch auction – A descending sequential-bid auction in which the auctioneer begins with a high asking price and gradually reduces the asking price until on bidder announces a willingness to pay that price for the item.
Each of the auctions also has many variations seen throughout the world and history. Additional information on these and lesser known types of auctions can be found at http://www.auctusdev.com/auctiontypes.html. One such variation of an English auction is the “Japanese auction.” In this auction, no new bidders can join after bidding has begun and after each bid, all players must either withdraw from the auction or declare their desire to continue. According to Auctus Development, Inc., a poker game is played in a similar fashion to a Japanese auction. Players must either match a raise or fold once a new bid has been placed.
The English auction is what generally comes to mind for people when they think of an auction. In an English auction, bidders are aware of other potential buyers’ bids and can then increase their bid in reaction to this information. An auction at Christie's or Sotheby's, for example, would be an English auction. Bidders attend the auction or call in bids. According to the Sotheby's website, bidding works exactly as described in the definition of an English auction: "After the auctioneer starts the bidding, they will accept incrementally higher bids until a sole bidder remains. This final bidder purchases the lot. However, if the bidding fails to reach the reserve price, the lot will pass unsold." (http://www.sothebys.com/en/buysell/auctions.html) A "silent auction" is also an English auction, but with a different structure. Instead of a live auctioneer announcing one item at a time, all items available are displayed simultaneously. Bidders look at items to be auctioned off and sign their names to a sheet of paper to indicate what price they would be willing to pay. When the auction ends, the person to sign the paper with the highest bid wins the item. eBay works similarly, but in an electronic format over the internet. When the time expires for the auction, the person with the highest bid wins. However, as we will discuss in second-price auctions, eBay is not a traditional English auction.
Silent auctions differ from traditional English auctions in that they are timed. In a traditional English auction, buyers continue to bid until no one is willing to pay a higher price than the last bidder and the auctioneer declares that the highest price has been accepted. In a silent auction, there could potentially be buyers with a higher willingness to pay who did not meet the time cut-off.
According to Dr. Baye's book, Managerial Economics and Business Strategy, if the auction is for an item valued based on the bidder's personal preferences, the bidder's best strategy in an English auction is to continue to increase his bid incrementally until he either wins the auction or an increase would cause him to go over his maximum willingness to pay for the item.
The next type of auction is a first-price, sealed-bid auction. In a first-price, sealed-bid auction, the buyers are motivated differently than in an English auction. In an English auction, buyers know that they can continue to bid lower than they would actually be willing to pay in order to increase their consumer surplus, because they will have continued opportunities to outbid other buyers. With a sealed-bid auction, the bidders get only one chance to place a bid and therefore must evaluate a bid that they are willing to pay and believe is higher than the bids that other buyers will place.
One real world example of this would be bidding on contracts. Many companies enter a bidding situation in order to receive business. Each of the bids is considered for its price and match to the needs of the company. Each company has the opportunity to bid once and is not privy to the bids of other companies. They may not even know how many other companies are bidding. In this example, unlike a traditional auction, bidders are bidding what they would get paid instead of what they would spend. So, in the case of contract bidding, the low price normally wins. Recently, tw telecom participated in such a competitive bidding process to provide serves to Fort Bragg. (http://www.marketwatch.com/story/tw-telecom-wins-multi-year-contract-to-provide-data-internet-and-ethernet-services-to-us-armys-ft-bragg-2011-10-03). During this auction, telecom companies competed with sealed bids that were evaluated based on the total value provided for the cost. In this case, that evaluation included “technical compliance, past performance and proposed costs.” TW Telecom’s goal when bidding should have been to put together the most valuable package at a cost less than that provided by their competitors, while still being able to maintain a profit. The difficulty here for tw telecom would have been imperfect information. They did not know the services and prices that their competitors would offer so instead needed to use the historical information available to them as well as their own valuation information to determine the best possible bid to try to maximize their surplus without losing the bid. If tw telecom had not been able to achieve a surplus without losing the bid, their best outcome would have been to not bid at all (if they had this information in advance) or to lose the bid. Winning the bid without maintaining surplus would result in a Winner’s Curse, which is discussed in detail in the disadvantages section of this paper.
According to Dr. Baye's book, Managerial Economics and Business Strategy, if the auction is for an item valued based on the bidder's personal preferences, the bidder's best strategy for a first-price, sealed-bid auction can be calculated using the formula b = v - ((v-L) / n), where v is the bidders personal valuation of the item, L is the lowest possible valuation of other bidders and n is the number of other bidders. B is the optimal bid amount. The important aspect of this formula is to note that if the bidder's valuation is close to the lowest possible valuation, or if there are a high number of bidders, the bidder is likely to optimally bid close to their valuation.
A second-price, sealed-bid auction is very similar to a first-price, sealed bid except that the winner of the auction pays the price offered by the next bidder - that is the second highest bid. A second-price, sealed-bid auction is also called a "Vickrey auction", named after economist William Vickrey. Vickrey was a Nobel Laureate noted for his paper Counterspeculation, auctions and competitive sealed tenders. (http://en.wikipedia.org/wiki/William_Vickrey).
While Vickrey auctions have many advantages, such as providing incentive for bidders to provide their real value to ensure they will win the item, they also have disadvantages, such as providing more incentive for collusion among buyers. Lawrence Ausubel and Paul Migrom discuss these and other advantages and disadvantages in their article Ascending Auctions with Package Bidding, published in the Frontiers of Theoretical Economics. (http://www.bepress.com/bejte/frontiers/vol1/iss1/art1).
One real-world example of a form of a second-price auction is eBay. On eBay, "incremental bidding" is used. (http://pages.ebay.com/help/buy/bidding-overview.html). The buyer enters the maximum amount that he is willing to pay (his reserve price) and eBay automatically increases the actual bid amount if the current bid amount is outbid up until the increase would go over the buyers maximum willingness to pay. By doing this, the bidder does not have to pay his reserve price, but rather pays a small increment more than the second-price.
According to Dr. Baye's book, Managerial Economics and Business Strategy, if the auction is for an item valued based on the bidder's personal preferences, the bidder's best strategy in a second-price auction is to bid his maximum willingness to pay for the item.
Dutch auctions work in reverse of a traditional, English auction. In a Dutch auction, the auctioneer starts with a high price and continues to lower it until a bidder is found. When Google went public, it used a form of a Dutch auction to auction off its shares. In this bid, all bidders simultaneously submitted their bids and then the top bidders were awarded with stocks, until all stocks had been sold. However, while the CNN article "The ABCs of a unique IPO" reports this as a "Dutch Auction," it is really more similar to a sealed bid auction in that all bids were submitted simultaneously and the highest bids were able to buy stock. Somewhat similar to a second-price auction, all buyers were able to purchase at the lowest accepted bidders price, rather than at their bid amount. To read the article, go to http://money.cnn.com/2004/04/29/technology/googleauction/. By using this method, Google was attempting to avoid an increase in the price of stocks the first day of trading that would then rapidly decline, as other technology firms had seen. This type of auction is being called a “modified Dutch auction” and is becoming increasingly popular. The concept of the “modified Dutch auction” or “Dutch Auction IPO” is explained by investopedia.com. (http://www.investopedia.com/terms/d/dutchauction.asp#axzz1evqQNvio). Basically, in a Dutch Auction IPO, “potential investors enter their bids for the number of shares they want to purchase as well as the price they are willing to pay. Once all the bids are submitted, the allotted placement is assigned to the bidders from the highest bids down, until all of the allotted shares are assigned. However, the price that each bidder pays is based on the lowest price of all the allotted bidders, or essentially the last successful bid.” Strategically, Dutch auctions are the same as first-price, sealed-bid auctions and bidders should optimally behave the same in both auction types.
Next, we will discuss why a buyer and a seller would prefer an auction. A company called "Walton and Associates" specializes in auctions, and on their website, they discuss some of the advantages of going to auction. According to Walton and Associates, "Auctions are the quickest and most efficient methods of selling goods at market value. The timeless simplicity of bringing buyers and sellers together in a live event goes back 1000's of years. The auction method of marketing allows buyers to attract sellers that are highly interested and highly qualified and allows them to compete for property." (http://www.waltonauctionsite.com/whyauction.html). Walton goes on to mention that auctions are a time-tested way to transition assets into cash, and that auctions are growing in popularity judging by their gross volume. One key driving benefit of an auction is that the time and terms of the sale are controllable by the seller. This is a large part of why auctions are so popular for government or business owned property, for example, a foreclosed home. The business would prefer a liquid asset, and by going to auction, they can set terms that the house be bought in cash and can set an auction date to ensure that the house is sold in a quick manner. This is also attractive to buyers, because investors able to meet the terms can often secure a better price than they would typically be able to get.
On the contrary, for unique items, auctions can also be beneficial to both parties but in a different way. When an item is rare or unique, it can be difficult for sellers to appropriately price and position the item to prospective buyers. By holding an auction, the item can be made available to all prospective buyers simultaneously and the seller is able to exchange the good with the buyer who has the highest reserve price and therefore values the item the most. This is advantageous for the buyer as well, because even if he may pay more for the item, he is able to purchase it when he otherwise might not have had the opportunity because another buyer who values the item less was able to get to the item first.
As previously discussed, each type of auction also has specific advantages over other auction types. For example, according to Leslie Fine, the Dutch auction has the advantage of speed. (http://www.econlib.org/library/Enc/Auctions.html#abouttheauthor) Because bidding only continues until a bidder is willing to pay that price, these auction types are very quick. Fine suggests this is the primary reason why Dutch auctions are used for places such as flower markets in Holland. English auctions offer the advantage of allowing bidders to adjust their valuation as they gain additional information. This will be discussed in more detail in the section of this paper on information.
Of course, auctions also have disadvantages. First, not all auctions give the players in the auction the same amount of information. For example, in sealed-bid auctions, bidders do not learn of other bidders bids until it is too late to act on that information. Further, valuations are often based on personal taste and therefore difficult to estimate for other bidders. These concerns are best relieved for bidders by an English auction, where valuation of other bidders can be determined by their willingness to continue to bid. Bidders must be careful to ensure that they firmly understand their own reserve price prior to entering an auction to avoid overbidding due to the excitement of participating in the auction and wanting to "win." This is one scenario that can lead to the "Winner's Curse." According to Epiq Technologies, a supply management solutions company, the Winner's Curse occurs when "winning bidders... end up paying more for an item than it is truly valued at." (http://www.epiqtech.com/auction_software-Overview.htm). The Winner's Curse is more likely to occur when bidders have imperfect information. For example, if a bidder is bidding on artwork but is unsure of the authenticity, he may be subject to the winner's curse if he is overly optimistic.
As pointed out in the Epiq Technologies article, the other major disadvantage of auctions is collusion. There is incentive for both sellers and buyers to participate in collusive activity. For sellers, it would be advantageous to drive auction prices higher, and therefore there is incentive to collude with buyers who will artificially inflate the bid. This collusion is only effective in an English auction. In a sealed-bid auction, this information would not be available to other bidders in time for them to adjust. In a Dutch auction, the "planted" buyer would automatically win the auction.
Buyers also have incentive to collude in some auction structures. In particular, in a second-price sealed-bid auction, buyer collusion could drastically reduce the total amount paid for the item. By convincing the second place bidder to bid substantially less than the bidder's actual reserve price, the winning bidder can bid high without risk of actually having to pay that price. Epiq Technologies also discusses the concept of bidders agreeing to not outbid one another, and then later auctioning the item off amongst them. This too keeps prices lower but keeps the seller from receiving the fair value of the item.
The amount of information bidders have also directly effects which auction type is likely to be most profitable for the seller. According to Dr. Baye's book, Managerial Economics and Business Strategy, when buyer's bids are based on personal tastes, expected revenues will be basically equivalent for all auction types. In English auctions, bidders will only bid the small percentage necessary to beat the "second-bidder." In second-price auctions, the winning bidder will pay the price offered by the second-bidder. In Dutch auctions and first-price, sealed-bid auctions, the bidder will try to estimate the second-bidder price and bid as close as possible to that price. In each of these cases, the expected revenues are roughly equivalent to the valuation of the second bidder. However, valuations in some auctions are not solely based on personal preference. When values are strongly affected by the "real value" of the item, such as in the case of land, or when valuation is affected by the valuation of others, such as in artwork where valuation may increase the more others appreciate the artwork, the type of auction can impact the total revenues the auctioneer can expect to collect. In these cases, an English auction is likely to produce the highest revenues, followed by a second-price sealed bid auction. First-price sealed-bid auctions and Dutch auctions will remain equivalent to each other, and will produce the least revenues of the auction types. The main difference here is that bidders are working to avoid the Winner's Curse. To do this, they lower their own bid to only their personal valuation of the item and do not include other factors that may increase their willingness to pay. English auctions, by providing the bidders with on-going information about other players' bids, somewhat lessen the chance of the Winner's Curse and provide buyers with more information allowing them to increase their valuation. In a second-price auction, buyers only have to pay the price of the "second bidder," which also mitigates the Winner's Curse to some extent by providing the valuation of the next highest bidder, but it mitigates to a lesser degree than an English auction does.
A November 8 article in the Wall Street Journal discusses the power of information at an auction to help bidders determine their valuation and bid strategy. The article discusses the upcoming auction for the Los Angeles Dodgers. (http://online.wsj.com/article/SB10001424052970204554204577024294161309650.html?mod=googlenews_wsj). In the article, it says that “People familiar with the strategy say the more a bidder knows about his future revenues, the more comfortable he will be raising his bid.” Largely, bidders will base their valuations on information such as the current value of the local-media rights and what comparable items have auctioned for in the past. This information is readily available in the article. Knowing that the Dodgers “now get roughly $37 million a year from the deal” and that at action last year the Texas Rangers were purchased for $593 million is some of the information that will help prospective buyers to determine their offer.
One particular auction has been discussed frequently in the last week as the result of the auction is being used as a signal of the overall health of the European economy. One example of an article on this subject can be found at http://www.businessweek.com/ap/financialnews/D9R6JQ500.htm. According to the Business Week article, on November 23, Germany went to bond auction to sell 10-year bonds equivalent to $8.1 billion USD. The auction was met with only 60% demand and Germany was unable to sell all of the bonds that it planned to issue. As discussed previously, one advantage of auctions is the ability to quickly sell goods at market value and to best ascertain the market value of items by allowing buyers to provide their valuation of an item. In this case, the concern for the German and European economy is not the strict value of the money that Germany was unable to collect, but rather that the valuation of the bidders is lower than the reserve price on bonds. These bidders are behaving in an environment with imperfect information and must estimate the value of the bond. The valuation estimation is interesting in that the "real value" of the bond would be equal to an investor who purchased it - there is no "personal taste" factor in the valuation. However, bidders will each estimate the value of the bond independently, and, as seen in this example, are very likely to determine different valuations. In the case of bonds, investors base their valuation on facts like the issue price, time to maturity and yield, but they also base their valuation on their confidence in the government issuing the bond. Germany has long been recognized as the strongest economy in the Eurozone (the group of countries who use the Euro as their currency) and the lack of ability to sell 40% of the debt issued has many investors worried about the future of the Eurozone. Further reinforcing the concern, Italy also went to auction this week to sell bonds and, in order to sell all of the bonds issued, had to accept a record-breaking 6.5%. (http://www.reuters.com/article/2011/11/25/uk-italy-bonds-auction-idUKTRE7AO0EN20111125).
These examples of auctions of bonds show that auctions are not only an effective way to buy and sell items, but also an effective way to get information about the valuations of both buyers and sellers. This valuation information can then be used to determine behavior in other markets or to predict future changes. For example, after the failure of the bonds auction for Germany, stock prices worldwide went down as buyers reacted to the new information. Further, these auctions are leading many to speculate about the future of the Euro and how the Eurozone will recover from its ongoing debt crises.
Auctions, at their root, are a form of market to allow the buying and selling of goods and services. To review, in an auction "potential buyers compete for the right to own a good, service, or, more generally, anything of value." Auctions have been used for thousands of years, but are becoming increasingly popular and well-known, particular through the invention of online auction sites. Auctions can come in many various forms, but generally fall in to one of the main four auction types: English, first-price sealed-bid, second-price sealed-bid, or Dutch. An English auction is what most people typically think of when they hear “auction.” It involves buyers bidding continuously until the no bidder is willing to pay more than the final bid. A first-price, sealed-bid auction is quite different. Buyers are not privy to the bids of other bidders and are only able to bid once. A second-price sealed-bid auction, similar to a first-price sealed-bid auction, only allows buyers to bid once, but the winning bidder pays the price offered by the second-highest bidder instead of his own bid amount. Finally, a Dutch auction is the reverse of an English auction. Starting with high prices, an auctioneer continues to lower the price until a bidder offers to buy at that price. The bidder then wins the item at the price called.
In all of its forms, an auction can bring many key benefits to both buyers and sellers. Auctions tend to be quick ways to convert assets into cash, sellers can set the terms of the auction as they see fit, and market information about valuation can generally be ascertained without substantial loss to either the buyer or the seller in the form of surplus. However, auctions also can result in a “Winner’s Curse” when a buyer either has incomplete information or overbids his reserve price, and can provide incentive for buyers to collude or sellers to collude with buyers to capture more of the available surplus. The better the information available to all parties, the more likely an auction is to result in the advantageous outcomes and avoid the potential pitfalls of the auction model.
In the real world, we can see how understanding auctions, auction types and the advantages and disadvantages provides a better tool for understanding and predicting buyer and seller behavior in auctions. Specifically, we can see how the behavior in the German debt auction signals investor valuation of the market, and we can use that information to predict future market events such as a decline in stock prices worldwide, or the potential dissolution of the Eurozone. But, according to Paul Klemperer of Nuffield College in Oxford, England, the advantages to studying auction theory do not stop there. (http://www.nuff.ox.ac.uk/users/klemperer/VirtualBook/VirtualBookCoverSheet.asp) Klemperer argues that the basic tenets of auction theory can be applied to many various economic situations to better understand and predict the behavior of participants. Klemperer says that using the tools of auction theory, we can better understand complex situations “including litigation systems, financial crashes, queues, and wars of attrition.” Understanding auction theory is a critical tool in understanding more complex economic concepts.
Ausubel, Lawrence M. and Milgrom, Paul R. "Ascending Auctions with Package Bidding," Frontiers of Theoretical Economics: Vol. 1: Iss. 1, Article 1. Aug. 8 2002. Web. <http://www.bepress.com/bejte/frontiers/vol1/iss1/art1>
As an auctioneer, you know that the item you are selling has a “real value” that is equivalent for all buyers. At which type of auction would you prefer to sell your item?
a. English
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
Which of the following is not a disadvantage of auctions?
a. Seller’s incentive to collude in a English auction
b. Speed of selling items
c. Buyer’s incentive to collude in a second-price auction
d. Winner’s curse
What concerns investors most about the recent auction of German debt?
a. Germany not receiving $26.25 billion USD it was hoping to gain from the sales
b. Apparent lack of confidence in the German economy
c. The slow sale of bonds
d. The lack of information about the quality of the bonds
You value an item at $100. You expect that 10 other people will bid on the item, and that they will value the item between $58 and $124. You are participating in a first-price, sealed-bid auction. What is your optimal bid?
a. $100.00
b. $58
c. $95.80
d. $91.00
You find out the auction will actually be a Dutch auction. What is your optimal bid now?
a. $100.00
b. $58
c. $95.80
d. $91.00
You also learn that the auction will now include 100 people. How does your optimal bid change?
a. It increases
b. It decreases
c. It stays the same
What type of auction is typically used when businesses bid on a contract? a. English
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
What makes a contract bid auction unique from most other types of auctions?
a. It always involves only 2 bidders
b. The seller is always a government agency
c. The winning bidder generally bids the lowest price
d. It is not different
Answer Key
As an auctioneer, you know that the item you are selling has a “real value” that is equivalent for all buyers. At which type of auction would you prefer to sell your item? a. English
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
An English auction is likely to produce the highest possible revenues, because buyers can continue to re-evaluate their valuation of the item as the compare it against others valuation and adjust their bid accordingly. They are less likely to suffer from the “Winner’s Curse” and are therefore more likely to continue to bid until their maximum willingness to pay is reached.
Which of the following is not a disadvantage of auctions?
a. Seller’s incentive to collude in a English auction b. Speed of selling items
c. Buyer’s incentive to collude in a second-price auction
d. Winner’s curse
The speed with which items can be sold is an advantage of auction models. In an English auction, sellers would be incentivized to collude with buyers to artificially raise the bids to capture additional surplus. In a second-price auction, buyers have incentive to collude to ensure they both win the item and reduce the amount that they must pay for it. The “Winner’s Curse” occurs when the valuation a bidder placed on the item turns out to be higher than their actual value for the item.
What concerns investors most about the recent auction of German debt?
a. Germany not receiving $26.25 billion USD it was hoping to gain from the sales b. Apparent lack of confidence in the German economy
c. The slow sale of bonds
d. The lack of information about the quality of the bonds
The lack of confidence in the German economy evidenced by the low valuation of German bonds is what has analysts most concerned about the Auction failure. All other factors, such as the number of bonds Germany was unable to sell, are being interpreted more as signals to the overall health of and confidence in the German and European economies.
You value an item at $100. You expect that 10 other people will bid on the item, and that they will value the item between $58 and $124. You are participating in a first-price, sealed-bid auction. What is your optimal bid?
a. $100.00
b. $58 c. $95.80
d. $91.00
Using the formula b = v - ((v-L) / n), you find that your optimal bid is $95.80. (v=$100, L=$58, n=10)
You find out the auction will actually be a Dutch auction. What is your optimal bid now?
a. $100.00
b. $58 c. $95.80
d. $91.00
Dutch auctions and first-price, sealed-bid auctions use the same strategy, so your bid will be the same.
You also learn that the auction will now include 100 people. How does your optimal bid change? a. It increases
b. It decreases
c. It stays the same
As the number of people increases, your optimal bid will become closer to your valuation.
What type of auction is typically used when business bid on a contract?
a. English
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
Contract bids normally are conducted as first-price sealed-bid auctions. Companies competing may not even know the number of bidders involved.
What makes a contract bid auction unique from most other types of auctions?
a. It always involves only 2 bidders
b. The seller is always a government agency c. The winning bidder generally bids the lowest price
d. It is not different
Because bidders are bidding to provide services rather than buy them, the winning price is generally the lowest cost that provides the services required.
Summaries
Summary of: “Information, Knowledge - include signaling, screening, asymmetric information, adverse selection, moral hazard.” By Melissa Wagner.
This paper discusses the power information has on the economy and economic theory. First, uncertainty is discussed. When a consumer is uncertain about the quality of a good, they will place a lower valuation on that item than they might if they were certain the good was high quality. So, for example, if they value a high quality good at $100 and a low quality good at $50, but they believe there is a 90% chance the good advertised as high quality will actually be low quality, they will only be willing to offer $55 for the good. But, if they are more certain that a good advertised as high quality really is, they will pay much more. In this example, if they believe there is only a 10% chance the good advertised as high quality will actually be low quality, they will be willing to offer $95. The willingness of a consumer to take a chance when they are uncertain is determined by how risk averse they are.
Next, the paper discusses how the firm responds to uncertainty of consumers. Essentially, the firm tries to either lower uncertainty by providing evidence of the quality of a good, or it accepts the lower price offer of the consumer for the good. In some cases, the firm can price discriminate and lower the price more for more risk averse consumers through the offer of coupons or warranties or guarantees.
Consumers are also sometimes uncertain of what the best available market price of an item is, and engage in a search to find the price. The consumer must balance the cost of the search with the expected benefit (savings) of the search. Melissa's paper points out that firms must also sometimes engage in searches to find the best price of inputs. Similarly, firms must balance the cost of the search with the expected benefit. Firms face additional uncertainty around the outcome of their investments. Because they cannot always be certain what the return on a project may be, many firms diversify to lower the risk associated with any one project.
Sometimes, the buyer has more information than the seller or the seller has more information than the buyer. This situation is called "asymmetric information." In these situations, two main problems, adverse selection and moral hazard, may arise. Adverse selection occurs when the party with the increased information takes advantage of that information to make a better buying/selling decision. Moral hazard occurs when the party with increased information changes his behavior after the transaction.
Finally, the paper discusses signaling and screening as a means of reducing asymmetri infomration. Signaling is used by sellers to assure buyers of the quality of their good. Sometimes, this is as simple as the brand name on a product, and other times it takes the form of an additional guarantee or warranty. Screening is used to filter through information to find the information that may be useful in making a buying or purchasing decision. Frequently, screeening tries to encourage the party with additional information to self-select.
Melissa's paper also has five multiple choice questions. These questions focus on understanding risk aversion, moral hazard and expected benefits. For question 3, you must assume that the prices are not visible to you when making the decision.
Summary of: “Concentration Indexes – Four firm concentration ratios, Herfindahl Hirschman indexes (HHI), Rothschild index, Lerner Index, Mergers ---- (See also Concentration’s Ratio Index on Blackboard under Assignment tab).” By Joshua Jackson
Joshua’s paper focuses on concentration indices and how they can be used to provide information about an industry. First, he discusses basic concentration ratios based on the four or eight largest firms in the industry. The main problems with concentration ratios are that they only provide general signs of concentration and competition and does not account for the market shares of all firms in the industry or the distribution of firm size. To reduce some of these problems, specificity measures like the pivotal supplier index (PSI) can help. Joshua explains the PSI and the Residual Supply Index and provides the information on how these are calculated.
Next, he explains the Herfindahl Hirschman Index (HHI) which is used to measure market concentration based on the market share of all firms in the industry. The HHI is used by the US Department of Justice when evaluating mergers. According to the questions at the end of the paper, the Rothschild Index is used to determine “the potential for change in social welfare by examining the effect of small changes in industry output.” Joshua next discusses the Lerner index, which describes a firm’s market power. Finally, he summarizes the limitations of concentration indexes. Notably, concentration ratios typically exclude foreign imports. This is important because the concentration of the firm may in reality be much lower when foreign companies are included. Next, concentration ratios focus on the national market, but do not account for local markets where the concentration ratio may be much higher. For example, there may be multiple providers of oil change services in the nation. However, a small town may only have one mechanic. Therefore, that mechanic has monopoly power in the local market but the concentration ratio is very low in the national market. Finally, concentration ratios depend heavily on how products are classified.
Summary of: “Government policies – Price ceilings, price floors, excise taxes, and the economic effects of prohibition (alcohol, drugs, kidneys, etc).” By Anthony Christofaro.
Anthony’s paper focuses on how government policies impact supply, demand and other basic tenets of economics. First, the paper focuses on Prohibition, the period between 1920 and 1933 in the United States when alcohol sales were illegal. Interestingly, Anthony’s paper first points out the economic reasons why prohibition was able to come in to effect in the first case. Because income taxes had recently been instated, the government was able to achieve its previous level of income without the excise taxes provided by alcohol sales, and achieve the same spot on its indifference curve. As such, the government gave in to the pressure to reduce alcohol sales. Repealing prohibition had similar economic reasoning. When the Great Depression began, people were making far less money and therefore contributing less to the income tax. By repealing prohibition, the government could once again increase its income to pre-Depression levels.
Next, Anthony discusses how today’s economic crisis could lead to further repeal of so called “Blue Laws.” Many places in the US still have restriction on alcohol sales, but many are also looking to change those restrictions. Anthony hypothesizes that the tough economic times could be one of the key factors driving legislators to want to change these laws. Further, he postulates that the same economic reasoning could also help to drive a lowering of the drinking age from 18 to 21. Anthony also discusses the negative sides of alcohol consumption on the national economy; specifically, he references the over $93 billion dollars federal, state and local governments spend related to the excessive use of alcohol. To face this negative downside of alcohol sales, and of other “undesirable” products, governments often institute “sin taxes.” According to the paper, these sin taxes serve two main purposes: to increase revenues to offset the negative costs the government faces as a result of their use, and to increase the cost of the products to consumers to reduce the quantity of the good demanded. Next, the paper discusses how the economics of alcohol restriction could also apply to marijuana restrictions, and Anthony speculates that marijuana will go the way of the 1920s prohibition on alcohol. He speculates that the current economic depression will likely be a catalyst in encouraging the government to legalize the sale of marijuana and use those sales as a source of revenue. In his summary, Anthony mentions other negative externalities associated with the restriction of alcohol sales, most notably increased crime and gang activity related to “bootlegging” alcohol.
Summary of: “Elasticity – elasticity of demand including Marginal revenue and the relationship with elasticity of demand. Also, elasticity of supply, cross price elasticity, income elasticity.” By Anqi Fang.
Anqi’s paper focuses on how elasticity impacts markets and various economic outcomes. First, Anqi discusses an article about the income elasticity of meat. Economically, he notes that the income elasticity of lamb, pork and poultry tend to be lower than other meats. Next, he discusses the importance of demand elasticity. First, he discusses the basic terms “elastic” and “inelastic” and says that when demand is inelastic, you should raise prices to increase revenues but when demand is elastic, raising prices will decrease sales. He next discusses the effect of competition on the elasticity for an individual firm’s goods. He also discusses how consumer loyalty can help to reduce the impact of competition on the elasticity of demand a firm faces. He also discusses two elasticities that insurance companies care about: the demand elasticity for insurance, which they hope is inelastic, and the demand elasticity for a specific provider’s services, which they hope is elastic. Price elasticity of demand is discussed next. In general, Anqi discusses that essentials tend to have very inelastic price elasticity, while non-necessities are much more elastic based on the price. From basic price elasticity, he moves on to cross price elasticity. Cross price elasticity of demand determines the impact of a change in the price of a different good on the good you are evaluating. He discusses how complementary goods have highly negative cross price elasticity while substitute goods have highly positive cross price elasticity. Specifically, he discusses that efforts like strengthening brand names and advertising are effective measures to try to reduce the cross-price elasticity of demand related to substitute goods, allowing firms to charge higher prices for their products.
Next, Anqi discusses articles that look at specific applications in industry of elasticities. The first looks at the applications of elasticities in transportation planning. For example, elasticities can be used to determine the optimal levels of road tolls to maximize profits and minimize negative externalities. The next focuses on health insurance and health care services and shows that the demand for health insurance does not change drastically based on price or consumer income. Finally, he looks at an article that shows a shift in the short-run elasticity of demand for gasoline. In recent years in America, price elasticity of demand for gasoline has become much more inelastic.
Anqi also looks at the price elasticity of supply. Similar to price elasticity of demand, price elasticity of supply measures the change in quantity when the price changes, but for change in quantity supplied instead of demanded.
Summary of: “Create and answer a case study similar to Memo 12 from Time Warner (Most Relevant Chapters 1, 8 and 11) that uses a cost-benefit analysis in determining what products or programs to keep.” By Sallie Horst.
In Sallie’s paper, she created a case study about a woman who is considering starting a business making custom dog beds or going back to work part-time. First, she analyzes the profit associated with each option, accounting for the costs involved. For dog beds, she will make an accounting profit of $46.30 per bed. By going back to work part-time, she would make accounting profits of $80 per week. Sallie then discusses the difference between economic profits and accounting profits, and discusses how economic profits account for implicit and explicit opportunity costs. Next, Sallie discusses the impact of the Five Forces on Martha Jane’s ability to start up the new company. Specifically, she discusses what the current forces will be for Martha Jane, and then how she will be able to favorably adjust those forces; by creating a one-of-a-kind item, direct substitution is not available. Martha Jane will also sell some of the beds on the Etsy website, where consumers would have no “buyer power.”
Sallie also discusses the elasticity of demand for the dog beds, and assumes that the elasticity will be relatively high – consumers will be sensitive to the price of the item. In part, she supports this assumption with the relative abundance of substitutes to fill the same need as a dog bed – from inexpensive, mass-market dog beds to more expensive custom dog beds. Sallie also notes that custom dog beds will be a normal good, as the demand would go up as consumer incomes go up, or down as they fall.
Inputs for Martha Jane’s new business will need to come through spot exchange. She will not develop contracts or on-going relationships with suppliers as her needs for inputs are too low to justify these relationships. Finally, Sallie discusses how Martha Jane will determine her final price for dog beds. Sallie references Baye’s book to find that most home producers sell their crafts at between 1.5 to 5 times their marginal cost, and assumes Martha will choose to sell at twice her marginal cost.
Sallie also discusses Martha Jane’s place in the market. She notes that Martha Jane will be in a monopolistically competitive market. Because her product will be differentiated, it is not a perfectly competitive market. Sallie also suggests that Martha Jane further differentiate her product by participating in social media, using more electronic advertising and tailoring her product to a niche. Finally, Sallie notes that Martha Jane will need to ensure that the market for her dog beds, given the recent economic crisis, is strong enough to support her business. This is related back to the concepts discussed earlier; Martha Jane will face an elastic demand and produce a normal good.
In conclusion, Sallie makes recommendations. She determines that Martha Jane will need to sell at least 7 dog beds to fully make up for the opportunity cost associated with taking the part-time job. However, Sallie notes that putting a value on the ability to be home with her child is difficult, so Martha Jane will have to determine how much less money she would be willing to make to stay home with her child when making this final decision.
Weekly posts Week of 10/3/2011 - Overview Prior to beginning a real world discussion of different types of auction and their resulting effect on buying and selling, it is important to understand a few key terms. According to Dr. Baye's book, Managerial Economics and Business Strategy, in an auction "potential buyers compete for the right to own a good, service, or, more generally, anything of value." In the coming weeks, I will discuss real-world applications of the following four types of auctions, as defined in Dr. Baye's book:
English auction - An ascending sequential-bid auction in which bidders observe the bids of others and decide whether or not to increase the bid. The auction ends when a single bidder remains; this bidder obtain the item and pays the auctioneer the amount of the bid.
First-price, sealed-bid auction - A simultaneous-move auction in which bidders simultaneously submit bids on pieces of paper. The auctioneer awards the item to the high bidder, who pays the amount bid.
Second-price, sealed-bid auction – A simultaneous-move auction in which bidders simultaneously submit bids. The auctioneer awards the item to the high bidder, who pays the amount bid by the second-highest bidder.
Dutch auction – A descending sequential-bid auction in which the auctioneer begins with a high asking price and gradually reduces the asking price until on bidder announces a willingness to pay that price for the item.
Each of the auctions also has many variations seen throughout the world and history. Additional information on these and lesser known types of auctions can be found at http://www.auctusdev.com/auctiontypes.html. One such variation of an English auction is the “Japanese auction.” In this auction, no new bidders can join after bidding has begun and after each bid, all players must either withdraw from the auction or declare their desire to continue. According to Auctus Development, Inc., a poker game is played in a similar fashion to a Japanese auction. Players must either match a raise or fold once a new bid has been placed. References & Links Auctus Development, Inc. Auction Strategy Consulting. Web. Accessed Oct. 2011. http://www.auctusdev.com/auctiontypes.html
Week of 10/10/2011 – English Auctions The English auction is what generally comes to mind for people when they think of an auction. In an English auction, bidders are aware of other potential buyers’ bids and can then increase their bid in reaction to this information. An auction at Christie's or Sotheby's, for example, would be an English auction. Bidders attend the auction or call in bids. According to the Sotheby's website, bidding works exactly as described in the definition of an English auction: "After the auctioneer starts the bidding, they will accept incrementally higher bids until a sole bidder remains. This final bidder purchases the lot. However, if the bidding fails to reach the reserve price, the lot will pass unsold." (http://www.sothebys.com/en/buysell/auctions.html) A "silent auction" is also an English auction, but with a different structure. Instead of a live auctioneer announcing one item at a time, all items available are displayed simultaneously. Bidders look at items to be auctioned off and sign their names to a sheet of paper to indicate what price they would be willing to pay. When the auction ends, the person to sign the paper with the highest bid wins the item. eBay works similarly, but in an electronic format over the internet. When the time expires for the auction, the person with the highest bid wins. However, as we will discuss in second-price auctions, eBay is not a traditional English auction. Silent auctions differ from traditional English auctions in that they are timed. In a traditional English auction, buyers continue to bid until no one is willing to pay a higher price than the last bidder and the auctioneer declares that the highest price has been accepted. In a silent auction, there could potentially be buyers with a higher willingness to pay who did not meet the time cut-off. According to Dr. Baye's book, Managerial Economics and Business Strategy, if the auction is for an item valued based on the bidder's personal preferences, the bidder's best strategy in an English auction is to continue to increase his bid incrementally until he either wins the auction or an increase would cause him to go over his maximum willingness to pay for the item. References & Links Sotheby’s. Web. Accessed Oct. 2011. <http://www.sothebys.com/en/buysell/auctions.html>
Week of 10/17/2011 – First-price, Sealed-bid Auctions The next type of auction is a first-price, sealed-bid auction. In a first-price, sealed-bid auction, the buyers are motivated differently than in an English auction. In an English auction, buyers know that they can continue to bid lower than they would actually be willing to pay in order to increase their consumer surplus, because they will have continued opportunities to outbid other buyers. With a sealed-bid auction, the bidders get only one chance to place a bid and therefore must evaluate a bid that they are willing to pay and believe is higher than the bids that other buyers will place. One real world example of this would be bidding on contracts. Many companies enter a bidding situation in order to receive business. Each of the bids is considered for its price and match to the needs of the company. Each company has the opportunity to bid once and is not privy to the bids of other companies. They may not even know how many other companies are bidding. In this example, unlike a traditional auction, bidders are bidding what they would get paid instead of what they would spend. So, in the case of contract bidding, the low price normally wins. Recently, tw telecom participated in such a competitive bidding process to provide serves to Fort Bragg. (http://www.marketwatch.com/story/tw-telecom-wins-multi-year-contract-to-provide-data-internet-and-ethernet-services-to-us-armys-ft-bragg-2011-10-03). During this auction, telecom companies competed with sealed bids that were evaluated based on the total value provided for the cost. In this case, that evaluation included “technical compliance, past performance and proposed costs.” TW Telecom’s goal when bidding should have been to put together the most valuable package at a cost less than that provided by their competitors, while still being able to maintain a profit. The difficulty here for tw telecom would have been imperfect information. They did not know the services and prices that their competitors would offer so instead needed to use the historical information available to them as well as their own valuation information to determine the best possible bid to try to maximize their surplus without losing the bid. If tw telecom had not been able to achieve a surplus without losing the bid, their best outcome would have been to not bid at all (if they had this information in advance) or to lose the bid. Winning the bid without maintaining surplus would result in a Winner’s Curse, which is discussed in detail in the disadvantages section of this paper. According to Dr. Baye's book, Managerial Economics and Business Strategy, if the auction is for an item valued based on the bidder's personal preferences, the bidder's best strategy for a first-price, sealed-bid auction can be calculated using the formula b = v - ((v-L) / n), where v is the bidders personal valuation of the item, L is the lowest possible valuation of other bidders and n is the number of other bidders. B is the optimal bid amount. The important aspect of this formula is to note that if the bidder's valuation is close to the lowest possible valuation, or if there are a high number of bidders, the bidder is likely to optimally bid close to their valuation. References & Links PR Newswire. “tw telecom Wins Multi-Year Contract to Provide Data, Internet and Ethernet Services to U.S. Army’s Ft. Bragg.” Marketwatch.com. Oct. 3 2011. Web. <http://www.marketwatch.com/story/tw-telecom-wins-multi-year-contract-to-provide-data-internet-and-ethernet-services-to-us-armys-ft-bragg-2011-10-03>
Week of 10/24/2011 – Second-price, Sealed-bid Auctions A second-price, sealed-bid auction is very similar to a first-price, sealed bid except that the winner of the auction pays the price offered by the next bidder - that is the second highest bid. A second-price, sealed-bid auction is also called a "Vickrey auction", named after economist William Vickrey. Vickrey was a Nobel Laureate noted for his paper Counterspeculation, auctions and competitive sealed tenders. (http://en.wikipedia.org/wiki/William_Vickrey). While Vickrey auctions have many advantages, such as providing incentive for bidders to provide their real value to ensure they will win the item, they also have disadvantages, such as providing more incentive for collusion among buyers. Lawrence Ausubel and Paul Migrom discuss these and other advantages and disadvantages in their article Ascending Auctions with Package Bidding, published in the Frontiers of Theoretical Economics. (http://www.bepress.com/bejte/frontiers/vol1/iss1/art1). One real-world example of a form of a second-price auction is eBay. On eBay, "incremental bidding" is used. (http://pages.ebay.com/help/buy/bidding-overview.html). The buyer enters the maximum amount that he is willing to pay (his reserve price) and eBay automatically increases the actual bid amount if the current bid amount is outbid up until the increase would go over the buyers maximum willingness to pay. By doing this, the bidder does not have to pay his reserve price, but rather pays a small increment more than the second-price. According to Dr. Baye's book, Managerial Economics and Business Strategy, if the auction is for an item valued based on the bidder's personal preferences, the bidder's best strategy in a second-price auction is to bid his maximum willingness to pay for the item. References & Links “William Vickrey.” Wikipedia.com. Web. <http://en.wikipedia.org/wiki/William_Vickrey>. Ausubel, Lawrence M. and Milgrom, Paul R. "Ascending Auctions with Package Bidding," Frontiers of Theoretical Economics: Vol. 1: Iss. 1, Article 1. Aug. 8 2002. Web. <http://www.bepress.com/bejte/frontiers/vol1/iss1/art1> “Bidding overview.” eBay.com. Web. <http://pages.ebay.com/help/buy/bidding-overview.html>
Week of 10/31/2011 – Dutch Auctions Dutch auctions work in reverse of a traditional, English auction. In a Dutch auction, the auctioneer starts with a high price and continues to lower it until a bidder is found. When Google went public, it used a form of a Dutch auction to auction off its shares. In this bid, all bidders simultaneously submitted their bids and then the top bidders were awarded with stocks, until all stocks had been sold. However, while the CNN article "The ABCs of a unique IPO" reports this as a "Dutch Auction," it is really more similar to a sealed bid auction in that all bids were submitted simultaneously and the highest bids were able to buy stock. Somewhat similar to a second-price auction, all buyers were able to purchase at the lowest accepted bidders price, rather than at their bid amount. To read the article, go to http://money.cnn.com/2004/04/29/technology/googleauction/. By using this method, Google was attempting to avoid an increase in the price of stocks the first day of trading that would then rapidly decline, as other technology firms had seen. This type of auction is being called a “modified Dutch auction” and is becoming increasingly popular. The concept of the “modified Dutch auction” or “Dutch Auction IPO” is explained by investopedia.com. (http://www.investopedia.com/terms/d/dutchauction.asp#axzz1evqQNvio). Basically, in a Dutch Auction IPO, “potential investors enter their bids for the number of shares they want to purchase as well as the price they are willing to pay. Once all the bids are submitted, the allotted placement is assigned to the bidders from the highest bids down, until all of the allotted shares are assigned. However, the price that each bidder pays is based on the lowest price of all the allotted bidders, or essentially the last successful bid.” Strategically, Dutch auctions are the same as first-price, sealed-bid auctions and bidders should optimally behave the same in both auction types. References & Links Christie, Les. “The ABCs of a unique IPO.” Money.cnn.com. Apr. 29 2004. Web. <http://money.cnn.com/2004/04/29/technology/googleauction/> “Dutch Auction.” Investopedia.com. Web. <http://www.investopedia.com/terms/d/dutchauction.asp#axzz1evqQNvio>
Week of 11/7/2011 – Advantages of Auctions In this section, we will discuss why a buyer and a seller would prefer an auction. A company called "Walton and Associates" specializes in auctions, and on their website, they discuss some of the advantages of going to auction. According to Walton and Associates, "Auctions are the quickest and most efficient methods of selling goods at market value. The timeless simplicity of bringing buyers and sellers together in a live event goes back 1000's of years. The auction method of marketing allows buyers to attract sellers that are highly interested and highly qualified and allows them to compete for property." (http://www.waltonauctionsite.com/whyauction.html). Walton goes on to mention that auctions are a time-tested way to transition assets into cash, and that auctions are growing in popularity judging by their gross volume. One key driving benefit of an auction is that the time and terms of the sale are controllable by the seller. This is a large part of why auctions are so popular for government or business owned property, for example, a foreclosed home. The business would prefer a liquid asset, and by going to auction, they can set terms that the house be bought in cash and can set an auction date to ensure that the house is sold in a quick manner. This is also attractive to buyers, because investors able to meet the terms can often secure a better price than they would typically be able to get. On the contrary, for unique items, auctions can also be beneficial to both parties but in a different way. When an item is rare or unique, it can be difficult for sellers to appropriately price and position the item to prospective buyers. By holding an auction, the item can be made available to all prospective buyers simultaneously and the seller is able to exchange the good with the buyer who has the highest reserve price and therefore values the item the most. This is advantageous for the buyer as well, because even if he may pay more for the item, he is able to purchase it when he otherwise might not have had the opportunity because another buyer who values the item less was able to get to the item first. As discussed in each section, each type of auction also has specific advantages over other auction types. For example, according to Leslie Fine, the Dutch auction has the advantage of speed. (http://www.econlib.org/library/Enc/Auctions.html#abouttheauthor) Because bidding only continues until a bidder is willing to pay that price, these auction types are very quick. Fine suggests this is the primary reason why Dutch auctions are used for places such as flower markets in Holland. English auctions offer the advantage of allowing bidders to adjust their valuation as they gain additional information. This will be discussed in more detail in the section of this paper on information. References & Links Walton & Associates. “Why Auction.” Waltonauctionsite.com. Web. <http://www.waltonauctionsite.com/whyauction.html> Leslie R. Fine, "Auctions." The Concise Encyclopedia of Economics. 2008. Library of Economics and Liberty. <http://www.econlib.org/library/Enc/Auctions.html>.
Week of 11/14/2011 – Disadvantages of Auctions Of course, auctions also have disadvantages. First, not all auctions give the players in the auction the same amount of information. For example, in sealed-bid auctions, bidders do not learn of other bidders bids until it is too late to act on that information. Further, valuations are often based on personal taste and therefore difficult to estimate for other bidders. These concerns are best relieved for bidders by an English auction, where valuation of other bidders can be determined by their willingness to continue to bid. Bidders must be careful to ensure that they firmly understand their own reserve price prior to entering an auction to avoid overbidding due to the excitement of participating in the auction and wanting to "win." This is one scenario that can lead to the "Winner's Curse." According to Epiq Technologies, a supply management solutions company, the Winner's Curse occurs when "winning bidders... end up paying more for an item than it is truly valued at." (http://www.epiqtech.com/auction_software-Overview.htm). The Winner's Curse is more likely to occur when bidders have imperfect information. For example, if a bidder is bidding on artwork but is unsure of the authenticity, he may be subject to the winner's curse if he is overly optimistic. As pointed out in the Epiq Technologies article, the other major disadvantage of auctions is collusion. There is incentive for both sellers and buyers to participate in collusive activity. For sellers, it would be advantageous to drive auction prices higher, and therefore there is incentive to collude with buyers who will artificially inflate the bid. This collusion is only effective in an English auction. In a sealed-bid auction, this information would not be available to other bidders in time for them to adjust. In a Dutch auction, the "planted" buyer would automatically win the auction. Buyers also have incentive to collude in some auction structures. In particular, in a second-price sealed-bid auction, buyer collusion could drastically reduce the total amount paid for the item. By convincing the second place bidder to bid substantially less than the bidder's actual reserve price, the winning bidder can bid high without risk of actually having to pay that price. Epiq Technologies also discusses the concept of bidders agreeing to not outbid one another, and then later auctioning the item off amongst them. This too keeps prices lower but keeps the seller from receiving the fair value of the item. References & Links “Auction Overview.” www.epiqtech.com Web. <http://www.epiqtech.com/auction_software-Overview.htm>
Week of 11/21/2011 – Effect of Information on Auctions The amount of information bidders have also directly effects which auction type is likely to be most profitable for the seller. According to Dr. Baye's book, Managerial Economics and Business Strategy, when buyer's bids are based on personal tastes, expected revenues will be basically equivalent for all auction types. In English auctions, bidders will only bid the small percentage necessary to beat the "second-bidder." In second-price auctions, the winning bidder will pay the price offered by the second-bidder. In Dutch auctions and first-price, sealed-bid auctions, the bidder will try to estimate the second-bidder price and bid as close as possible to that price. In each of these cases, the expected revenues are roughly equivalent to the valuation of the second bidder. However, valuations in some auctions are not solely based on personal preference. When values are strongly affected by the "real value" of the item, such as in the case of land, or when valuation is affected by the valuation of others, such as in artwork where valuation may increase the more others appreciate the artwork, the type of auction can impact the total revenues the auctioneer can expect to collect. In these cases, an English auction is likely to produce the highest revenues, followed by a second-price sealed bid auction. First-price sealed-bid auctions and Dutch auctions will remain equivalent to each other, and will produce the least revenues of the auction types. The main difference here is that bidders are working to avoid the Winner's Curse. To do this, they lower their own bid to only their personal valuation of the item and do not include other factors that may increase their willingness to pay. English auctions, by providing the bidders with on-going information about other players' bids, somewhat lessen the chance of the Winner's Curse and provide buyers with more information allowing them to increase their valuation. In a second-price auction, buyers only have to pay the price of the "second bidder," which also mitigates the Winner's Curse to some extent by providing the valuation of the next highest bidder, but it mitigates to a lesser degree than an English auction does. A November 8 article in the Wall Street Journal discusses the power of information at an auction to help bidders determine their valuation and bid strategy. The article discusses the upcoming auction for the Los Angeles Dodgers. (http://online.wsj.com/article/SB10001424052970204554204577024294161309650.html?mod=googlenews_wsj). In the article, it says that “People familiar with the strategy say the more a bidder knows about his future revenues, the more comfortable he will be raising his bid.” Largely, bidders will base their valuations on information such as the current value of the local-media rights and what comparable items have auctioned for in the past. This information is readily available in the article. Knowing that the Dodgers “now get roughly $37 million a year from the deal” and that at action last year the Texas Rangers were purchased for $593 million is some of the information that will help prospective buyers to determine their offer. References & Links Futterman, Matthew. “Auction Plan Set for Dodgers.” Wall Street Journal. Nov.8 2011. Web. <http://online.wsj.com/article/SB10001424052970204554204577024294161309650.html?mod=googlenews_wsj>
Week of 11/28/2011 – Debt Auctions One particular auction has been discussed frequently in the last week as the result of the auction is being used as a signal of the overall health of the European economy. One example of an article on this subject can be found at http://www.businessweek.com/ap/financialnews/D9R6JQ500.htm. According to the Business Week article, on November 23, Germany went to bond auction to sell 10-year bonds equivalent to $8.1 billion USD. The auction was met with only 60% demand and Germany was unable to sell all of the bonds that it planned to issue. As discussed previously, one advantage of auctions is the ability to quickly sell goods at market value and to best ascertain the market value of items by allowing buyers to provide their valuation of an item. In this case, the concern for the German and European economy is not the strict value of the money that Germany was unable to collect, but rather that the valuation of the bidders is lower than the reserve price on bonds. These bidders are behaving in an environment with imperfect information and must estimate the value of the bond. The valuation estimation is interesting in that the "real value" of the bond would be equal to an investor who purchased it - there is no "personal taste" factor in the valuation. However, bidders will each estimate the value of the bond independently, and, as seen in this example, are very likely to determine different valuations. In the case of bonds, investors base their valuation on facts like the issue price, time to maturity and yield, but they also base their valuation on their confidence in the government issuing the bond. Germany has long been recognized as the strongest economy in the Eurozone (the group of countries who use the Euro as their currency) and the lack of ability to sell 40% of the debt issued has many investors worried about the future of the Eurozone. Further reinforcing the concern, Italy also went to auction this week to sell bonds and, in order to sell all of the bonds issued, had to accept a record-breaking 6.5%. (http://www.reuters.com/article/2011/11/25/uk-italy-bonds-auction-idUKTRE7AO0EN20111125). These examples of auctions of bonds show that auctions are not only an effective way to buy and sell items, but also an effective way to get information about the valuations of both buyers and sellers. This valuation information can then be used to determine behavior in other markets or to predict future changes. For example, after the failure of the bonds auction for Germany, stock prices worldwide went down as buyers reacted to the new information. Further, these auctions are leading many to speculate about the future of the Euro and how the Eurozone will recover from its ongoing debt crises. References & Links Baetz, Juergen and Casert, Raf. “Germany’s auction flop adds to European debt fears.” The Associated Press and Bloomberg Businessweek. Nov.23 2011. Web. <http://www.businessweek.com/ap/financialnews/D9R6JQ500.htm> Za, Valentina. “‘Awful’ Italy debt sale heightens euro zone stress.” Reuters.com Nov. 25 2011. Web. <http://www.reuters.com/article/2011/11/25/uk-italy-bonds-auction-idUKTRE7AO0EN20111125>
Summary and Multiple Choice Auctions, at their root, are a form of market to allow the buying and selling of goods and services. To review, in an auction "potential buyers compete for the right to own a good, service, or, more generally, anything of value." Auctions have been used for thousands of years, but are becoming increasingly popular and well-known, particular through the invention of online auction sites. Auctions can come in many various forms, but generally fall in to one of the main four auction types: English, first-price sealed-bid, second-price sealed-bid, or Dutch. An English auction is what most people typically think of when they hear “auction.” It involves buyers bidding continuously until the no bidder is willing to pay more than the final bid. A first-price, sealed-bid auction is quite different. Buyers are not privy to the bids of other bidders and are only able to bid once. A second-price sealed-bid auction, similar to a first-price sealed-bid auction, only allows buyers to bid once, but the winning bidder pays the price offered by the second-highest bidder instead of his own bid amount. Finally, a Dutch auction is the reverse of an English auction. Starting with high prices, an auctioneer continues to lower the price until a bidder offers to buy at that price. The bidder then wins the item at the price called. In all of its forms, an auction can bring many key benefits to both buyers and sellers. Auctions tend to be quick ways to convert assets into cash, sellers can set the terms of the auction as they see fit, and market information about valuation can generally be ascertained without substantial loss to either the buyer or the seller in the form of surplus. However, auctions also can result in a “Winner’s Curse” when a buyer either has incomplete information or overbids his reserve price, and can provide incentive for buyers to collude or sellers to collude with buyers to capture more of the available surplus. The better the information available to all parties, the more likely an auction is to result in the advantageous outcomes and avoid the potential pitfalls of the auction model. In the real world, we can see how understanding auctions, auction types and the advantages and disadvantages provides a better tool for understanding and predicting buyer and seller behavior in auctions. Specifically, we can see how the behavior in the German debt auction signals investor valuation of the market, and we can use that information to predict future market events such as a decline in stock prices worldwide, or the potential dissolution of the Eurozone. But, according to Paul Klemperer of Nuffield College in Oxford, England, the advantages to studying auction theory do not stop there. (http://www.nuff.ox.ac.uk/users/klemperer/VirtualBook/VirtualBookCoverSheet.asp) Klemperer argues that the basic tenets of auction theory can be applied to many various economic situations to better understand and predict the behavior of participants. Klemperer says that using the tools of auction theory, we can better understand complex situations “including litigation systems, financial crashes, queues, and wars of attrition.” Understanding auction theory is a critical tool in understanding more complex economic concepts. References & Links Klemperer, Paul. “Auctions: Theory and Practice” Oxford, England: Princeton University Press, 2004. Web. <http://www.nuff.ox.ac.uk/users/klemperer/VirtualBook/VirtualBookCoverSheet.asp>
Multiple Choice Questions
As an auctioneer, you know that the item you are selling has a “real value” that is equivalent for all buyers. At which type of auction would you prefer to sell your item?
a. English
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
Which of the following is not a disadvantage of auctions?
a. Seller’s incentive to collude in a English auction
b. Speed of selling items
c. Buyer’s incentive to collude in a second-price auction d. Winner’s curse
What concerns investors most about the recent auction of German debt?
a. Germany not receiving $26.25 billion USD it was hoping to gain from the sales
b. Apparent lack of confidence in the German economy
c. The slow sale of bonds
d. The lack of information about the quality of the bonds
You value an item at $100. You expect that 10 other people will bid on the item, and that they will value the item between $58 and $124. You are participating in a first-price, sealed-bid auction. What is your optimal bid?
a. $100.00
b. $58
c. $95.80
d. $91.00
You find out the auction will actually be a Dutch auction. What is your optimal bid now?
a. $100.00
b. $58
c. $95.80
d. $91.00
You also learn that the auction will now include 100 people. How does your optimal bid change?
a. It increases
b. It decreases
c. It stays the same
What type of auction is typically used when businesses bid on a contract? a. English
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid What makes a contract bid auction unique from most other types of auctions?
a. It always involves only 2 bidders
b. The seller is always a government agency
c. The winning bidder generally bids the lowest price
d. It is not different
Answer Key
As an auctioneer, you know that the item you are selling has a “real value” that is equivalent for all buyers. At which type of auction would you prefer to sell your item?a. English b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
An English auction is likely to produce the highest possible revenues, because buyers can continue to re-evaluate their valuation of the item as the compare it against others valuation and adjust their bid accordingly. They are less likely to suffer from the “Winner’s Curse” and are therefore more likely to continue to bid until their maximum willingness to pay is reached.
Which of the following is not a disadvantage of auctions?
a. Seller’s incentive to collude in a English auction b. Speed of selling items c. Buyer’s incentive to collude in a second-price auction d. Winner’s curse The speed with which items can be sold is an advantage of auction models. In an English auction, sellers would be incentivized to collude with buyers to artificially raise the bids to capture additional surplus. In a second-price auction, buyers have incentive to collude to ensure they both win the item and reduce the amount that they must pay for it. The “Winner’s Curse” occurs when the valuation a bidder placed on the item turns out to be higher than their actual value for the item.
What concerns investors most about the recent auction of German debt?
a. Germany not receiving $26.25 billion USD it was hoping to gain from the sales b. Apparent lack of confidence in the German economy
c. The slow sale of bonds d. The lack of information about the quality of the bonds The lack of confidence in the German economy evidenced by the low valuation of German bonds is what has analysts most concerned about the Auction failure. All other factors, such as the number of bonds Germany was unable to sell, are being interpreted more as signals to the overall health of and confidence in the German and European economies.
You value an item at $100. You expect that 10 other people will bid on the item, and that they will value the item between $58 and $124. You are participating in a first-price, sealed-bid auction. What is your optimal bid?
a. $100.00
b. $58 c. $95.80 d. $91.00
Using the formula b = v - ((v-L) / n), you find that your optimal bid is $95.80. (v=$100, L=$58, n=10)
You find out the auction will actually be a Dutch auction. What is your optimal bid now?
a. $100.00
b. $58 c. $95.80 d. $91.00
Dutch auctions and first-price, sealed-bid auctions use the same strategy, so your bid will be the same.
You also learn that the auction will now include 100 people. How does your optimal bid change? a. It increases b. It decreases
c. It stays the same
As the number of people increases, your optimal bid will become closer to your valuation.
What type of auction is typically used when business bid on a contract?
a. English
b. Dutch
c. First-price sealed-bid d. Second-price sealed-bid
Contract bids normally are conducted as first-price sealed-bid auctions. Companies competing may not even know the number of bidders involved.
What makes a contract bid auction unique from most other types of auctions?
a. It always involves only 2 bidders
b. The seller is always a government agency c. The winning bidder generally bids the lowest price d. It is not different
Because bidders are bidding to provide services rather than buy them, the winning price is generally the lowest cost that provides the services required.
Kristin Westerfield
Final Paper
Prior to beginning a real world discussion of different types of auction and their resulting effect on buying and selling, it is important to understand a few key terms. According to Dr. Baye's book, Managerial Economics and Business Strategy, in an auction "potential buyers compete for the right to own a good, service, or, more generally, anything of value." In the coming weeks, I will discuss real-world applications of the following four types of auctions, as defined in Dr. Baye's book:
Each of the auctions also has many variations seen throughout the world and history. Additional information on these and lesser known types of auctions can be found at http://www.auctusdev.com/auctiontypes.html. One such variation of an English auction is the “Japanese auction.” In this auction, no new bidders can join after bidding has begun and after each bid, all players must either withdraw from the auction or declare their desire to continue. According to Auctus Development, Inc., a poker game is played in a similar fashion to a Japanese auction. Players must either match a raise or fold once a new bid has been placed.
The English auction is what generally comes to mind for people when they think of an auction. In an English auction, bidders are aware of other potential buyers’ bids and can then increase their bid in reaction to this information. An auction at Christie's or Sotheby's, for example, would be an English auction. Bidders attend the auction or call in bids. According to the Sotheby's website, bidding works exactly as described in the definition of an English auction: "After the auctioneer starts the bidding, they will accept incrementally higher bids until a sole bidder remains. This final bidder purchases the lot. However, if the bidding fails to reach the reserve price, the lot will pass unsold." (http://www.sothebys.com/en/buysell/auctions.html) A "silent auction" is also an English auction, but with a different structure. Instead of a live auctioneer announcing one item at a time, all items available are displayed simultaneously. Bidders look at items to be auctioned off and sign their names to a sheet of paper to indicate what price they would be willing to pay. When the auction ends, the person to sign the paper with the highest bid wins the item. eBay works similarly, but in an electronic format over the internet. When the time expires for the auction, the person with the highest bid wins. However, as we will discuss in second-price auctions, eBay is not a traditional English auction.
Silent auctions differ from traditional English auctions in that they are timed. In a traditional English auction, buyers continue to bid until no one is willing to pay a higher price than the last bidder and the auctioneer declares that the highest price has been accepted. In a silent auction, there could potentially be buyers with a higher willingness to pay who did not meet the time cut-off.
According to Dr. Baye's book, Managerial Economics and Business Strategy, if the auction is for an item valued based on the bidder's personal preferences, the bidder's best strategy in an English auction is to continue to increase his bid incrementally until he either wins the auction or an increase would cause him to go over his maximum willingness to pay for the item.
The next type of auction is a first-price, sealed-bid auction. In a first-price, sealed-bid auction, the buyers are motivated differently than in an English auction. In an English auction, buyers know that they can continue to bid lower than they would actually be willing to pay in order to increase their consumer surplus, because they will have continued opportunities to outbid other buyers. With a sealed-bid auction, the bidders get only one chance to place a bid and therefore must evaluate a bid that they are willing to pay and believe is higher than the bids that other buyers will place.
One real world example of this would be bidding on contracts. Many companies enter a bidding situation in order to receive business. Each of the bids is considered for its price and match to the needs of the company. Each company has the opportunity to bid once and is not privy to the bids of other companies. They may not even know how many other companies are bidding. In this example, unlike a traditional auction, bidders are bidding what they would get paid instead of what they would spend. So, in the case of contract bidding, the low price normally wins. Recently, tw telecom participated in such a competitive bidding process to provide serves to Fort Bragg. (http://www.marketwatch.com/story/tw-telecom-wins-multi-year-contract-to-provide-data-internet-and-ethernet-services-to-us-armys-ft-bragg-2011-10-03). During this auction, telecom companies competed with sealed bids that were evaluated based on the total value provided for the cost. In this case, that evaluation included “technical compliance, past performance and proposed costs.” TW Telecom’s goal when bidding should have been to put together the most valuable package at a cost less than that provided by their competitors, while still being able to maintain a profit. The difficulty here for tw telecom would have been imperfect information. They did not know the services and prices that their competitors would offer so instead needed to use the historical information available to them as well as their own valuation information to determine the best possible bid to try to maximize their surplus without losing the bid. If tw telecom had not been able to achieve a surplus without losing the bid, their best outcome would have been to not bid at all (if they had this information in advance) or to lose the bid. Winning the bid without maintaining surplus would result in a Winner’s Curse, which is discussed in detail in the disadvantages section of this paper.
According to Dr. Baye's book, Managerial Economics and Business Strategy, if the auction is for an item valued based on the bidder's personal preferences, the bidder's best strategy for a first-price, sealed-bid auction can be calculated using the formula b = v - ((v-L) / n), where v is the bidders personal valuation of the item, L is the lowest possible valuation of other bidders and n is the number of other bidders. B is the optimal bid amount. The important aspect of this formula is to note that if the bidder's valuation is close to the lowest possible valuation, or if there are a high number of bidders, the bidder is likely to optimally bid close to their valuation.
A second-price, sealed-bid auction is very similar to a first-price, sealed bid except that the winner of the auction pays the price offered by the next bidder - that is the second highest bid. A second-price, sealed-bid auction is also called a "Vickrey auction", named after economist William Vickrey. Vickrey was a Nobel Laureate noted for his paper Counterspeculation, auctions and competitive sealed tenders. (http://en.wikipedia.org/wiki/William_Vickrey).
While Vickrey auctions have many advantages, such as providing incentive for bidders to provide their real value to ensure they will win the item, they also have disadvantages, such as providing more incentive for collusion among buyers. Lawrence Ausubel and Paul Migrom discuss these and other advantages and disadvantages in their article Ascending Auctions with Package Bidding, published in the Frontiers of Theoretical Economics. (http://www.bepress.com/bejte/frontiers/vol1/iss1/art1).
One real-world example of a form of a second-price auction is eBay. On eBay, "incremental bidding" is used. (http://pages.ebay.com/help/buy/bidding-overview.html). The buyer enters the maximum amount that he is willing to pay (his reserve price) and eBay automatically increases the actual bid amount if the current bid amount is outbid up until the increase would go over the buyers maximum willingness to pay. By doing this, the bidder does not have to pay his reserve price, but rather pays a small increment more than the second-price.
According to Dr. Baye's book, Managerial Economics and Business Strategy, if the auction is for an item valued based on the bidder's personal preferences, the bidder's best strategy in a second-price auction is to bid his maximum willingness to pay for the item.
Dutch auctions work in reverse of a traditional, English auction. In a Dutch auction, the auctioneer starts with a high price and continues to lower it until a bidder is found. When Google went public, it used a form of a Dutch auction to auction off its shares. In this bid, all bidders simultaneously submitted their bids and then the top bidders were awarded with stocks, until all stocks had been sold. However, while the CNN article "The ABCs of a unique IPO" reports this as a "Dutch Auction," it is really more similar to a sealed bid auction in that all bids were submitted simultaneously and the highest bids were able to buy stock. Somewhat similar to a second-price auction, all buyers were able to purchase at the lowest accepted bidders price, rather than at their bid amount. To read the article, go to http://money.cnn.com/2004/04/29/technology/googleauction/. By using this method, Google was attempting to avoid an increase in the price of stocks the first day of trading that would then rapidly decline, as other technology firms had seen. This type of auction is being called a “modified Dutch auction” and is becoming increasingly popular. The concept of the “modified Dutch auction” or “Dutch Auction IPO” is explained by investopedia.com. (http://www.investopedia.com/terms/d/dutchauction.asp#axzz1evqQNvio). Basically, in a Dutch Auction IPO, “potential investors enter their bids for the number of shares they want to purchase as well as the price they are willing to pay. Once all the bids are submitted, the allotted placement is assigned to the bidders from the highest bids down, until all of the allotted shares are assigned. However, the price that each bidder pays is based on the lowest price of all the allotted bidders, or essentially the last successful bid.” Strategically, Dutch auctions are the same as first-price, sealed-bid auctions and bidders should optimally behave the same in both auction types.
Next, we will discuss why a buyer and a seller would prefer an auction. A company called "Walton and Associates" specializes in auctions, and on their website, they discuss some of the advantages of going to auction. According to Walton and Associates, "Auctions are the quickest and most efficient methods of selling goods at market value. The timeless simplicity of bringing buyers and sellers together in a live event goes back 1000's of years. The auction method of marketing allows buyers to attract sellers that are highly interested and highly qualified and allows them to compete for property." (http://www.waltonauctionsite.com/whyauction.html). Walton goes on to mention that auctions are a time-tested way to transition assets into cash, and that auctions are growing in popularity judging by their gross volume. One key driving benefit of an auction is that the time and terms of the sale are controllable by the seller. This is a large part of why auctions are so popular for government or business owned property, for example, a foreclosed home. The business would prefer a liquid asset, and by going to auction, they can set terms that the house be bought in cash and can set an auction date to ensure that the house is sold in a quick manner. This is also attractive to buyers, because investors able to meet the terms can often secure a better price than they would typically be able to get.
On the contrary, for unique items, auctions can also be beneficial to both parties but in a different way. When an item is rare or unique, it can be difficult for sellers to appropriately price and position the item to prospective buyers. By holding an auction, the item can be made available to all prospective buyers simultaneously and the seller is able to exchange the good with the buyer who has the highest reserve price and therefore values the item the most. This is advantageous for the buyer as well, because even if he may pay more for the item, he is able to purchase it when he otherwise might not have had the opportunity because another buyer who values the item less was able to get to the item first.
As previously discussed, each type of auction also has specific advantages over other auction types. For example, according to Leslie Fine, the Dutch auction has the advantage of speed. (http://www.econlib.org/library/Enc/Auctions.html#abouttheauthor) Because bidding only continues until a bidder is willing to pay that price, these auction types are very quick. Fine suggests this is the primary reason why Dutch auctions are used for places such as flower markets in Holland. English auctions offer the advantage of allowing bidders to adjust their valuation as they gain additional information. This will be discussed in more detail in the section of this paper on information.
Of course, auctions also have disadvantages. First, not all auctions give the players in the auction the same amount of information. For example, in sealed-bid auctions, bidders do not learn of other bidders bids until it is too late to act on that information. Further, valuations are often based on personal taste and therefore difficult to estimate for other bidders. These concerns are best relieved for bidders by an English auction, where valuation of other bidders can be determined by their willingness to continue to bid. Bidders must be careful to ensure that they firmly understand their own reserve price prior to entering an auction to avoid overbidding due to the excitement of participating in the auction and wanting to "win." This is one scenario that can lead to the "Winner's Curse." According to Epiq Technologies, a supply management solutions company, the Winner's Curse occurs when "winning bidders... end up paying more for an item than it is truly valued at." (http://www.epiqtech.com/auction_software-Overview.htm). The Winner's Curse is more likely to occur when bidders have imperfect information. For example, if a bidder is bidding on artwork but is unsure of the authenticity, he may be subject to the winner's curse if he is overly optimistic.
As pointed out in the Epiq Technologies article, the other major disadvantage of auctions is collusion. There is incentive for both sellers and buyers to participate in collusive activity. For sellers, it would be advantageous to drive auction prices higher, and therefore there is incentive to collude with buyers who will artificially inflate the bid. This collusion is only effective in an English auction. In a sealed-bid auction, this information would not be available to other bidders in time for them to adjust. In a Dutch auction, the "planted" buyer would automatically win the auction.
Buyers also have incentive to collude in some auction structures. In particular, in a second-price sealed-bid auction, buyer collusion could drastically reduce the total amount paid for the item. By convincing the second place bidder to bid substantially less than the bidder's actual reserve price, the winning bidder can bid high without risk of actually having to pay that price. Epiq Technologies also discusses the concept of bidders agreeing to not outbid one another, and then later auctioning the item off amongst them. This too keeps prices lower but keeps the seller from receiving the fair value of the item.
The amount of information bidders have also directly effects which auction type is likely to be most profitable for the seller. According to Dr. Baye's book, Managerial Economics and Business Strategy, when buyer's bids are based on personal tastes, expected revenues will be basically equivalent for all auction types. In English auctions, bidders will only bid the small percentage necessary to beat the "second-bidder." In second-price auctions, the winning bidder will pay the price offered by the second-bidder. In Dutch auctions and first-price, sealed-bid auctions, the bidder will try to estimate the second-bidder price and bid as close as possible to that price. In each of these cases, the expected revenues are roughly equivalent to the valuation of the second bidder. However, valuations in some auctions are not solely based on personal preference. When values are strongly affected by the "real value" of the item, such as in the case of land, or when valuation is affected by the valuation of others, such as in artwork where valuation may increase the more others appreciate the artwork, the type of auction can impact the total revenues the auctioneer can expect to collect. In these cases, an English auction is likely to produce the highest revenues, followed by a second-price sealed bid auction. First-price sealed-bid auctions and Dutch auctions will remain equivalent to each other, and will produce the least revenues of the auction types. The main difference here is that bidders are working to avoid the Winner's Curse. To do this, they lower their own bid to only their personal valuation of the item and do not include other factors that may increase their willingness to pay. English auctions, by providing the bidders with on-going information about other players' bids, somewhat lessen the chance of the Winner's Curse and provide buyers with more information allowing them to increase their valuation. In a second-price auction, buyers only have to pay the price of the "second bidder," which also mitigates the Winner's Curse to some extent by providing the valuation of the next highest bidder, but it mitigates to a lesser degree than an English auction does.
A November 8 article in the Wall Street Journal discusses the power of information at an auction to help bidders determine their valuation and bid strategy. The article discusses the upcoming auction for the Los Angeles Dodgers. (http://online.wsj.com/article/SB10001424052970204554204577024294161309650.html?mod=googlenews_wsj). In the article, it says that “People familiar with the strategy say the more a bidder knows about his future revenues, the more comfortable he will be raising his bid.” Largely, bidders will base their valuations on information such as the current value of the local-media rights and what comparable items have auctioned for in the past. This information is readily available in the article. Knowing that the Dodgers “now get roughly $37 million a year from the deal” and that at action last year the Texas Rangers were purchased for $593 million is some of the information that will help prospective buyers to determine their offer.
One particular auction has been discussed frequently in the last week as the result of the auction is being used as a signal of the overall health of the European economy. One example of an article on this subject can be found at http://www.businessweek.com/ap/financialnews/D9R6JQ500.htm. According to the Business Week article, on November 23, Germany went to bond auction to sell 10-year bonds equivalent to $8.1 billion USD. The auction was met with only 60% demand and Germany was unable to sell all of the bonds that it planned to issue. As discussed previously, one advantage of auctions is the ability to quickly sell goods at market value and to best ascertain the market value of items by allowing buyers to provide their valuation of an item. In this case, the concern for the German and European economy is not the strict value of the money that Germany was unable to collect, but rather that the valuation of the bidders is lower than the reserve price on bonds. These bidders are behaving in an environment with imperfect information and must estimate the value of the bond. The valuation estimation is interesting in that the "real value" of the bond would be equal to an investor who purchased it - there is no "personal taste" factor in the valuation. However, bidders will each estimate the value of the bond independently, and, as seen in this example, are very likely to determine different valuations. In the case of bonds, investors base their valuation on facts like the issue price, time to maturity and yield, but they also base their valuation on their confidence in the government issuing the bond. Germany has long been recognized as the strongest economy in the Eurozone (the group of countries who use the Euro as their currency) and the lack of ability to sell 40% of the debt issued has many investors worried about the future of the Eurozone. Further reinforcing the concern, Italy also went to auction this week to sell bonds and, in order to sell all of the bonds issued, had to accept a record-breaking 6.5%. (http://www.reuters.com/article/2011/11/25/uk-italy-bonds-auction-idUKTRE7AO0EN20111125).
These examples of auctions of bonds show that auctions are not only an effective way to buy and sell items, but also an effective way to get information about the valuations of both buyers and sellers. This valuation information can then be used to determine behavior in other markets or to predict future changes. For example, after the failure of the bonds auction for Germany, stock prices worldwide went down as buyers reacted to the new information. Further, these auctions are leading many to speculate about the future of the Euro and how the Eurozone will recover from its ongoing debt crises.
Auctions, at their root, are a form of market to allow the buying and selling of goods and services. To review, in an auction "potential buyers compete for the right to own a good, service, or, more generally, anything of value." Auctions have been used for thousands of years, but are becoming increasingly popular and well-known, particular through the invention of online auction sites. Auctions can come in many various forms, but generally fall in to one of the main four auction types: English, first-price sealed-bid, second-price sealed-bid, or Dutch. An English auction is what most people typically think of when they hear “auction.” It involves buyers bidding continuously until the no bidder is willing to pay more than the final bid. A first-price, sealed-bid auction is quite different. Buyers are not privy to the bids of other bidders and are only able to bid once. A second-price sealed-bid auction, similar to a first-price sealed-bid auction, only allows buyers to bid once, but the winning bidder pays the price offered by the second-highest bidder instead of his own bid amount. Finally, a Dutch auction is the reverse of an English auction. Starting with high prices, an auctioneer continues to lower the price until a bidder offers to buy at that price. The bidder then wins the item at the price called.
In all of its forms, an auction can bring many key benefits to both buyers and sellers. Auctions tend to be quick ways to convert assets into cash, sellers can set the terms of the auction as they see fit, and market information about valuation can generally be ascertained without substantial loss to either the buyer or the seller in the form of surplus. However, auctions also can result in a “Winner’s Curse” when a buyer either has incomplete information or overbids his reserve price, and can provide incentive for buyers to collude or sellers to collude with buyers to capture more of the available surplus. The better the information available to all parties, the more likely an auction is to result in the advantageous outcomes and avoid the potential pitfalls of the auction model.
In the real world, we can see how understanding auctions, auction types and the advantages and disadvantages provides a better tool for understanding and predicting buyer and seller behavior in auctions. Specifically, we can see how the behavior in the German debt auction signals investor valuation of the market, and we can use that information to predict future market events such as a decline in stock prices worldwide, or the potential dissolution of the Eurozone. But, according to Paul Klemperer of Nuffield College in Oxford, England, the advantages to studying auction theory do not stop there. (http://www.nuff.ox.ac.uk/users/klemperer/VirtualBook/VirtualBookCoverSheet.asp) Klemperer argues that the basic tenets of auction theory can be applied to many various economic situations to better understand and predict the behavior of participants. Klemperer says that using the tools of auction theory, we can better understand complex situations “including litigation systems, financial crashes, queues, and wars of attrition.” Understanding auction theory is a critical tool in understanding more complex economic concepts.
Bibliography
“Auction Overview.” www.epiqtech.com Web. <http://www.epiqtech.com/auction_software-Overview.htm>
Auctus Development, Inc. Auction Strategy Consulting. Web. Accessed Oct. 2011. http://www.auctusdev.com/auctiontypes.html
Ausubel, Lawrence M. and Milgrom, Paul R. "Ascending Auctions with Package Bidding," Frontiers of Theoretical Economics: Vol. 1: Iss. 1, Article 1. Aug. 8 2002. Web. <http://www.bepress.com/bejte/frontiers/vol1/iss1/art1>
Baetz, Juergen and Casert, Raf. “Germany’s auction flop adds to European debt fears.” The Associated Press and Bloomberg Businessweek. Nov.23 2011. Web. <http://www.businessweek.com/ap/financialnews/D9R6JQ500.htm>
Baye, Michael R. Managerial Economics and Business Strategy, 7th edition. McGraw-Hill/Irwin, 2010. Print.
“Bidding overview.” eBay.com. Web. <http://pages.ebay.com/help/buy/bidding-overview.html>
Christie, Les. “The ABCs of a unique IPO.” Money.cnn.com. Apr. 29 2004. Web. <http://money.cnn.com/2004/04/29/technology/googleauction/>
“Dutch Auction.” Investopedia.com. Web. <http://www.investopedia.com/terms/d/dutchauction.asp#axzz1evqQNvio>
Futterman, Matthew. “Auction Plan Set for Dodgers.” Wall Street Journal. Nov.8 2011. Web. <http://online.wsj.com/article/SB10001424052970204554204577024294161309650.html?mod=googlenews_wsj>
Klemperer, Paul. “Auctions: Theory and Practice” Oxford, England: Princeton University Press, 2004. Web. <http://www.nuff.ox.ac.uk/users/klemperer/VirtualBook/VirtualBookCoverSheet.asp>
Leslie R. Fine, "Auctions." The Concise Encyclopedia of Economics. 2008. Library of Economics and Liberty. <http://www.econlib.org/library/Enc/Auctions.html>.
PR Newswire. “tw telecom Wins Multi-Year Contract to Provide Data, Internet and Ethernet Services to U.S. Army’s Ft. Bragg.” Marketwatch.com. Oct. 3 2011. Web. <http://www.marketwatch.com/story/tw-telecom-wins-multi-year-contract-to-provide-data-internet-and-ethernet-services-to-us-armys-ft-bragg-2011-10-03>
Sotheby’s. Web. Accessed Oct. 2011. <http://www.sothebys.com/en/buysell/auctions.html>
Walton & Associates. “Why Auction.” Waltonauctionsite.com. Web. <http://www.waltonauctionsite.com/whyauction.html>
“William Vickrey.” Wikipedia.com. Web. <http://en.wikipedia.org/wiki/William_Vickrey>.
Za, Valentina. “‘Awful’ Italy debt sale heightens euro zone stress.” Reuters.com Nov. 25 2011. Web. <http://www.reuters.com/article/2011/11/25/uk-italy-bonds-auction-idUKTRE7AO0EN20111125>
Multiple Choice Questions
- As an auctioneer, you know that the item you are selling has a “real value” that is equivalent for all buyers. At which type of auction would you prefer to sell your item?
- Which of the following is not a disadvantage of auctions?
- What concerns investors most about the recent auction of German debt?
- What type of auction is typically used when businesses bid on a contract? a. English
Answer Keya. English
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
a. Seller’s incentive to collude in a English auction
b. Speed of selling items
c. Buyer’s incentive to collude in a second-price auction
d. Winner’s curse
a. Germany not receiving $26.25 billion USD it was hoping to gain from the sales
b. Apparent lack of confidence in the German economy
c. The slow sale of bonds
d. The lack of information about the quality of the bonds
You value an item at $100. You expect that 10 other people will bid on the item, and that they will value the item between $58 and $124. You are participating in a first-price, sealed-bid auction. What is your optimal bid?
a. $100.00
b. $58
c. $95.80
d. $91.00
You find out the auction will actually be a Dutch auction. What is your optimal bid now?
a. $100.00
b. $58
c. $95.80
d. $91.00
You also learn that the auction will now include 100 people. How does your optimal bid change?
a. It increases
b. It decreases
c. It stays the same
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
What makes a contract bid auction unique from most other types of auctions?
a. It always involves only 2 bidders
b. The seller is always a government agency
c. The winning bidder generally bids the lowest price
d. It is not different
- As an auctioneer, you know that the item you are selling has a “real value” that is equivalent for all buyers. At which type of auction would you prefer to sell your item?
An English auction is likely to produce the highest possible revenues, because buyers can continue to re-evaluate their valuation of the item as the compare it against others valuation and adjust their bid accordingly. They are less likely to suffer from the “Winner’s Curse” and are therefore more likely to continue to bid until their maximum willingness to pay is reached.a. English
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
a. Seller’s incentive to collude in a English auction
b. Speed of selling items
c. Buyer’s incentive to collude in a second-price auction
d. Winner’s curse
The speed with which items can be sold is an advantage of auction models. In an English auction, sellers would be incentivized to collude with buyers to artificially raise the bids to capture additional surplus. In a second-price auction, buyers have incentive to collude to ensure they both win the item and reduce the amount that they must pay for it. The “Winner’s Curse” occurs when the valuation a bidder placed on the item turns out to be higher than their actual value for the item.
a. Germany not receiving $26.25 billion USD it was hoping to gain from the sales
b. Apparent lack of confidence in the German economy
c. The slow sale of bonds
d. The lack of information about the quality of the bonds
The lack of confidence in the German economy evidenced by the low valuation of German bonds is what has analysts most concerned about the Auction failure. All other factors, such as the number of bonds Germany was unable to sell, are being interpreted more as signals to the overall health of and confidence in the German and European economies.
a. $100.00
b. $58
c. $95.80
d. $91.00
Using the formula b = v - ((v-L) / n), you find that your optimal bid is $95.80. (v=$100, L=$58, n=10)
You find out the auction will actually be a Dutch auction. What is your optimal bid now?
a. $100.00
b. $58
c. $95.80
d. $91.00
Dutch auctions and first-price, sealed-bid auctions use the same strategy, so your bid will be the same.
You also learn that the auction will now include 100 people. How does your optimal bid change?
a. It increases
b. It decreases
c. It stays the same
As the number of people increases, your optimal bid will become closer to your valuation.
a. English
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
Contract bids normally are conducted as first-price sealed-bid auctions. Companies competing may not even know the number of bidders involved.
What makes a contract bid auction unique from most other types of auctions?
a. It always involves only 2 bidders
b. The seller is always a government agency
c. The winning bidder generally bids the lowest price
d. It is not different
Because bidders are bidding to provide services rather than buy them, the winning price is generally the lowest cost that provides the services required.
Summaries
Summary of: “Information, Knowledge - include signaling, screening, asymmetric information, adverse selection, moral hazard.” By Melissa Wagner.
This paper discusses the power information has on the economy and economic theory. First, uncertainty is discussed. When a consumer is uncertain about the quality of a good, they will place a lower valuation on that item than they might if they were certain the good was high quality. So, for example, if they value a high quality good at $100 and a low quality good at $50, but they believe there is a 90% chance the good advertised as high quality will actually be low quality, they will only be willing to offer $55 for the good. But, if they are more certain that a good advertised as high quality really is, they will pay much more. In this example, if they believe there is only a 10% chance the good advertised as high quality will actually be low quality, they will be willing to offer $95. The willingness of a consumer to take a chance when they are uncertain is determined by how risk averse they are.
Next, the paper discusses how the firm responds to uncertainty of consumers. Essentially, the firm tries to either lower uncertainty by providing evidence of the quality of a good, or it accepts the lower price offer of the consumer for the good. In some cases, the firm can price discriminate and lower the price more for more risk averse consumers through the offer of coupons or warranties or guarantees.
Consumers are also sometimes uncertain of what the best available market price of an item is, and engage in a search to find the price. The consumer must balance the cost of the search with the expected benefit (savings) of the search. Melissa's paper points out that firms must also sometimes engage in searches to find the best price of inputs. Similarly, firms must balance the cost of the search with the expected benefit. Firms face additional uncertainty around the outcome of their investments. Because they cannot always be certain what the return on a project may be, many firms diversify to lower the risk associated with any one project.
Sometimes, the buyer has more information than the seller or the seller has more information than the buyer. This situation is called "asymmetric information." In these situations, two main problems, adverse selection and moral hazard, may arise. Adverse selection occurs when the party with the increased information takes advantage of that information to make a better buying/selling decision. Moral hazard occurs when the party with increased information changes his behavior after the transaction.
Finally, the paper discusses signaling and screening as a means of reducing asymmetri infomration. Signaling is used by sellers to assure buyers of the quality of their good. Sometimes, this is as simple as the brand name on a product, and other times it takes the form of an additional guarantee or warranty. Screening is used to filter through information to find the information that may be useful in making a buying or purchasing decision. Frequently, screeening tries to encourage the party with additional information to self-select.
Melissa's paper also has five multiple choice questions. These questions focus on understanding risk aversion, moral hazard and expected benefits. For question 3, you must assume that the prices are not visible to you when making the decision.
Summary of: “Concentration Indexes – Four firm concentration ratios, Herfindahl Hirschman indexes (HHI), Rothschild index, Lerner Index, Mergers ---- (See also Concentration’s Ratio Index on Blackboard under Assignment tab).” By Joshua Jackson
Joshua’s paper focuses on concentration indices and how they can be used to provide information about an industry. First, he discusses basic concentration ratios based on the four or eight largest firms in the industry. The main problems with concentration ratios are that they only provide general signs of concentration and competition and does not account for the market shares of all firms in the industry or the distribution of firm size. To reduce some of these problems, specificity measures like the pivotal supplier index (PSI) can help. Joshua explains the PSI and the Residual Supply Index and provides the information on how these are calculated.
Next, he explains the Herfindahl Hirschman Index (HHI) which is used to measure market concentration based on the market share of all firms in the industry. The HHI is used by the US Department of Justice when evaluating mergers. According to the questions at the end of the paper, the Rothschild Index is used to determine “the potential for change in social welfare by examining the effect of small changes in industry output.” Joshua next discusses the Lerner index, which describes a firm’s market power. Finally, he summarizes the limitations of concentration indexes. Notably, concentration ratios typically exclude foreign imports. This is important because the concentration of the firm may in reality be much lower when foreign companies are included. Next, concentration ratios focus on the national market, but do not account for local markets where the concentration ratio may be much higher. For example, there may be multiple providers of oil change services in the nation. However, a small town may only have one mechanic. Therefore, that mechanic has monopoly power in the local market but the concentration ratio is very low in the national market. Finally, concentration ratios depend heavily on how products are classified.
Summary of: “Government policies – Price ceilings, price floors, excise taxes, and the economic effects of prohibition (alcohol, drugs, kidneys, etc).” By Anthony Christofaro.
Anthony’s paper focuses on how government policies impact supply, demand and other basic tenets of economics. First, the paper focuses on Prohibition, the period between 1920 and 1933 in the United States when alcohol sales were illegal. Interestingly, Anthony’s paper first points out the economic reasons why prohibition was able to come in to effect in the first case. Because income taxes had recently been instated, the government was able to achieve its previous level of income without the excise taxes provided by alcohol sales, and achieve the same spot on its indifference curve. As such, the government gave in to the pressure to reduce alcohol sales. Repealing prohibition had similar economic reasoning. When the Great Depression began, people were making far less money and therefore contributing less to the income tax. By repealing prohibition, the government could once again increase its income to pre-Depression levels.
Next, Anthony discusses how today’s economic crisis could lead to further repeal of so called “Blue Laws.” Many places in the US still have restriction on alcohol sales, but many are also looking to change those restrictions. Anthony hypothesizes that the tough economic times could be one of the key factors driving legislators to want to change these laws. Further, he postulates that the same economic reasoning could also help to drive a lowering of the drinking age from 18 to 21. Anthony also discusses the negative sides of alcohol consumption on the national economy; specifically, he references the over $93 billion dollars federal, state and local governments spend related to the excessive use of alcohol. To face this negative downside of alcohol sales, and of other “undesirable” products, governments often institute “sin taxes.” According to the paper, these sin taxes serve two main purposes: to increase revenues to offset the negative costs the government faces as a result of their use, and to increase the cost of the products to consumers to reduce the quantity of the good demanded.
Next, the paper discusses how the economics of alcohol restriction could also apply to marijuana restrictions, and Anthony speculates that marijuana will go the way of the 1920s prohibition on alcohol. He speculates that the current economic depression will likely be a catalyst in encouraging the government to legalize the sale of marijuana and use those sales as a source of revenue.
In his summary, Anthony mentions other negative externalities associated with the restriction of alcohol sales, most notably increased crime and gang activity related to “bootlegging” alcohol.
Summary of: “Elasticity – elasticity of demand including Marginal revenue and the relationship with elasticity of demand. Also, elasticity of supply, cross price elasticity, income elasticity.” By Anqi Fang.
Anqi’s paper focuses on how elasticity impacts markets and various economic outcomes. First, Anqi discusses an article about the income elasticity of meat. Economically, he notes that the income elasticity of lamb, pork and poultry tend to be lower than other meats.
Next, he discusses the importance of demand elasticity. First, he discusses the basic terms “elastic” and “inelastic” and says that when demand is inelastic, you should raise prices to increase revenues but when demand is elastic, raising prices will decrease sales. He next discusses the effect of competition on the elasticity for an individual firm’s goods. He also discusses how consumer loyalty can help to reduce the impact of competition on the elasticity of demand a firm faces. He also discusses two elasticities that insurance companies care about: the demand elasticity for insurance, which they hope is inelastic, and the demand elasticity for a specific provider’s services, which they hope is elastic.
Price elasticity of demand is discussed next. In general, Anqi discusses that essentials tend to have very inelastic price elasticity, while non-necessities are much more elastic based on the price. From basic price elasticity, he moves on to cross price elasticity. Cross price elasticity of demand determines the impact of a change in the price of a different good on the good you are evaluating. He discusses how complementary goods have highly negative cross price elasticity while substitute goods have highly positive cross price elasticity. Specifically, he discusses that efforts like strengthening brand names and advertising are effective measures to try to reduce the cross-price elasticity of demand related to substitute goods, allowing firms to charge higher prices for their products.
Next, Anqi discusses articles that look at specific applications in industry of elasticities. The first looks at the applications of elasticities in transportation planning. For example, elasticities can be used to determine the optimal levels of road tolls to maximize profits and minimize negative externalities. The next focuses on health insurance and health care services and shows that the demand for health insurance does not change drastically based on price or consumer income. Finally, he looks at an article that shows a shift in the short-run elasticity of demand for gasoline. In recent years in America, price elasticity of demand for gasoline has become much more inelastic.
Anqi also looks at the price elasticity of supply. Similar to price elasticity of demand, price elasticity of supply measures the change in quantity when the price changes, but for change in quantity supplied instead of demanded.
Summary of: “Create and answer a case study similar to Memo 12 from Time Warner (Most Relevant Chapters 1, 8 and 11) that uses a cost-benefit analysis in determining what products or programs to keep.” By Sallie Horst.
In Sallie’s paper, she created a case study about a woman who is considering starting a business making custom dog beds or going back to work part-time. First, she analyzes the profit associated with each option, accounting for the costs involved. For dog beds, she will make an accounting profit of $46.30 per bed. By going back to work part-time, she would make accounting profits of $80 per week. Sallie then discusses the difference between economic profits and accounting profits, and discusses how economic profits account for implicit and explicit opportunity costs.
Next, Sallie discusses the impact of the Five Forces on Martha Jane’s ability to start up the new company. Specifically, she discusses what the current forces will be for Martha Jane, and then how she will be able to favorably adjust those forces; by creating a one-of-a-kind item, direct substitution is not available. Martha Jane will also sell some of the beds on the Etsy website, where consumers would have no “buyer power.”
Sallie also discusses the elasticity of demand for the dog beds, and assumes that the elasticity will be relatively high – consumers will be sensitive to the price of the item. In part, she supports this assumption with the relative abundance of substitutes to fill the same need as a dog bed – from inexpensive, mass-market dog beds to more expensive custom dog beds. Sallie also notes that custom dog beds will be a normal good, as the demand would go up as consumer incomes go up, or down as they fall.
Inputs for Martha Jane’s new business will need to come through spot exchange. She will not develop contracts or on-going relationships with suppliers as her needs for inputs are too low to justify these relationships. Finally, Sallie discusses how Martha Jane will determine her final price for dog beds. Sallie references Baye’s book to find that most home producers sell their crafts at between 1.5 to 5 times their marginal cost, and assumes Martha will choose to sell at twice her marginal cost.
Sallie also discusses Martha Jane’s place in the market. She notes that Martha Jane will be in a monopolistically competitive market. Because her product will be differentiated, it is not a perfectly competitive market. Sallie also suggests that Martha Jane further differentiate her product by participating in social media, using more electronic advertising and tailoring her product to a niche. Finally, Sallie notes that Martha Jane will need to ensure that the market for her dog beds, given the recent economic crisis, is strong enough to support her business. This is related back to the concepts discussed earlier; Martha Jane will face an elastic demand and produce a normal good.
In conclusion, Sallie makes recommendations. She determines that Martha Jane will need to sell at least 7 dog beds to fully make up for the opportunity cost associated with taking the part-time job. However, Sallie notes that putting a value on the ability to be home with her child is difficult, so Martha Jane will have to determine how much less money she would be willing to make to stay home with her child when making this final decision.
Weekly posts
Week of 10/3/2011 - Overview
Prior to beginning a real world discussion of different types of auction and their resulting effect on buying and selling, it is important to understand a few key terms. According to Dr. Baye's book, Managerial Economics and Business Strategy, in an auction "potential buyers compete for the right to own a good, service, or, more generally, anything of value." In the coming weeks, I will discuss real-world applications of the following four types of auctions, as defined in Dr. Baye's book:
- English auction - An ascending sequential-bid auction in which bidders observe the bids of others and decide whether or not to increase the bid. The auction ends when a single bidder remains; this bidder obtain the item and pays the auctioneer the amount of the bid.
- First-price, sealed-bid auction - A simultaneous-move auction in which bidders simultaneously submit bids on pieces of paper. The auctioneer awards the item to the high bidder, who pays the amount bid.
- Second-price, sealed-bid auction – A simultaneous-move auction in which bidders simultaneously submit bids. The auctioneer awards the item to the high bidder, who pays the amount bid by the second-highest bidder.
- Dutch auction – A descending sequential-bid auction in which the auctioneer begins with a high asking price and gradually reduces the asking price until on bidder announces a willingness to pay that price for the item.
Each of the auctions also has many variations seen throughout the world and history. Additional information on these and lesser known types of auctions can be found at http://www.auctusdev.com/auctiontypes.html. One such variation of an English auction is the “Japanese auction.” In this auction, no new bidders can join after bidding has begun and after each bid, all players must either withdraw from the auction or declare their desire to continue. According to Auctus Development, Inc., a poker game is played in a similar fashion to a Japanese auction. Players must either match a raise or fold once a new bid has been placed.References & Links
Auctus Development, Inc. Auction Strategy Consulting. Web. Accessed Oct. 2011. http://www.auctusdev.com/auctiontypes.html
Week of 10/10/2011 – English Auctions
The English auction is what generally comes to mind for people when they think of an auction. In an English auction, bidders are aware of other potential buyers’ bids and can then increase their bid in reaction to this information. An auction at Christie's or Sotheby's, for example, would be an English auction. Bidders attend the auction or call in bids. According to the Sotheby's website, bidding works exactly as described in the definition of an English auction: "After the auctioneer starts the bidding, they will accept incrementally higher bids until a sole bidder remains. This final bidder purchases the lot. However, if the bidding fails to reach the reserve price, the lot will pass unsold." (http://www.sothebys.com/en/buysell/auctions.html) A "silent auction" is also an English auction, but with a different structure. Instead of a live auctioneer announcing one item at a time, all items available are displayed simultaneously. Bidders look at items to be auctioned off and sign their names to a sheet of paper to indicate what price they would be willing to pay. When the auction ends, the person to sign the paper with the highest bid wins the item. eBay works similarly, but in an electronic format over the internet. When the time expires for the auction, the person with the highest bid wins. However, as we will discuss in second-price auctions, eBay is not a traditional English auction.
Silent auctions differ from traditional English auctions in that they are timed. In a traditional English auction, buyers continue to bid until no one is willing to pay a higher price than the last bidder and the auctioneer declares that the highest price has been accepted. In a silent auction, there could potentially be buyers with a higher willingness to pay who did not meet the time cut-off.
According to Dr. Baye's book, Managerial Economics and Business Strategy, if the auction is for an item valued based on the bidder's personal preferences, the bidder's best strategy in an English auction is to continue to increase his bid incrementally until he either wins the auction or an increase would cause him to go over his maximum willingness to pay for the item.
References & Links
Sotheby’s. Web. Accessed Oct. 2011. <http://www.sothebys.com/en/buysell/auctions.html>
Week of 10/17/2011 – First-price, Sealed-bid Auctions
The next type of auction is a first-price, sealed-bid auction. In a first-price, sealed-bid auction, the buyers are motivated differently than in an English auction. In an English auction, buyers know that they can continue to bid lower than they would actually be willing to pay in order to increase their consumer surplus, because they will have continued opportunities to outbid other buyers. With a sealed-bid auction, the bidders get only one chance to place a bid and therefore must evaluate a bid that they are willing to pay and believe is higher than the bids that other buyers will place.
One real world example of this would be bidding on contracts. Many companies enter a bidding situation in order to receive business. Each of the bids is considered for its price and match to the needs of the company. Each company has the opportunity to bid once and is not privy to the bids of other companies. They may not even know how many other companies are bidding. In this example, unlike a traditional auction, bidders are bidding what they would get paid instead of what they would spend. So, in the case of contract bidding, the low price normally wins. Recently, tw telecom participated in such a competitive bidding process to provide serves to Fort Bragg. (http://www.marketwatch.com/story/tw-telecom-wins-multi-year-contract-to-provide-data-internet-and-ethernet-services-to-us-armys-ft-bragg-2011-10-03). During this auction, telecom companies competed with sealed bids that were evaluated based on the total value provided for the cost. In this case, that evaluation included “technical compliance, past performance and proposed costs.” TW Telecom’s goal when bidding should have been to put together the most valuable package at a cost less than that provided by their competitors, while still being able to maintain a profit. The difficulty here for tw telecom would have been imperfect information. They did not know the services and prices that their competitors would offer so instead needed to use the historical information available to them as well as their own valuation information to determine the best possible bid to try to maximize their surplus without losing the bid. If tw telecom had not been able to achieve a surplus without losing the bid, their best outcome would have been to not bid at all (if they had this information in advance) or to lose the bid. Winning the bid without maintaining surplus would result in a Winner’s Curse, which is discussed in detail in the disadvantages section of this paper.
According to Dr. Baye's book, Managerial Economics and Business Strategy, if the auction is for an item valued based on the bidder's personal preferences, the bidder's best strategy for a first-price, sealed-bid auction can be calculated using the formula b = v - ((v-L) / n), where v is the bidders personal valuation of the item, L is the lowest possible valuation of other bidders and n is the number of other bidders. B is the optimal bid amount. The important aspect of this formula is to note that if the bidder's valuation is close to the lowest possible valuation, or if there are a high number of bidders, the bidder is likely to optimally bid close to their valuation.
References & Links
PR Newswire. “tw telecom Wins Multi-Year Contract to Provide Data, Internet and Ethernet Services to U.S. Army’s Ft. Bragg.” Marketwatch.com. Oct. 3 2011. Web. <http://www.marketwatch.com/story/tw-telecom-wins-multi-year-contract-to-provide-data-internet-and-ethernet-services-to-us-armys-ft-bragg-2011-10-03>
Week of 10/24/2011 – Second-price, Sealed-bid Auctions
A second-price, sealed-bid auction is very similar to a first-price, sealed bid except that the winner of the auction pays the price offered by the next bidder - that is the second highest bid. A second-price, sealed-bid auction is also called a "Vickrey auction", named after economist William Vickrey. Vickrey was a Nobel Laureate noted for his paper Counterspeculation, auctions and competitive sealed tenders. (http://en.wikipedia.org/wiki/William_Vickrey).
While Vickrey auctions have many advantages, such as providing incentive for bidders to provide their real value to ensure they will win the item, they also have disadvantages, such as providing more incentive for collusion among buyers. Lawrence Ausubel and Paul Migrom discuss these and other advantages and disadvantages in their article Ascending Auctions with Package Bidding, published in the Frontiers of Theoretical Economics. (http://www.bepress.com/bejte/frontiers/vol1/iss1/art1).
One real-world example of a form of a second-price auction is eBay. On eBay, "incremental bidding" is used. (http://pages.ebay.com/help/buy/bidding-overview.html). The buyer enters the maximum amount that he is willing to pay (his reserve price) and eBay automatically increases the actual bid amount if the current bid amount is outbid up until the increase would go over the buyers maximum willingness to pay. By doing this, the bidder does not have to pay his reserve price, but rather pays a small increment more than the second-price.
According to Dr. Baye's book, Managerial Economics and Business Strategy, if the auction is for an item valued based on the bidder's personal preferences, the bidder's best strategy in a second-price auction is to bid his maximum willingness to pay for the item.
References & Links
“William Vickrey.” Wikipedia.com. Web. <http://en.wikipedia.org/wiki/William_Vickrey>.
Ausubel, Lawrence M. and Milgrom, Paul R. "Ascending Auctions with Package Bidding," Frontiers of Theoretical Economics: Vol. 1: Iss. 1, Article 1. Aug. 8 2002. Web. <http://www.bepress.com/bejte/frontiers/vol1/iss1/art1>
“Bidding overview.” eBay.com. Web. <http://pages.ebay.com/help/buy/bidding-overview.html>
Week of 10/31/2011 – Dutch Auctions
Dutch auctions work in reverse of a traditional, English auction. In a Dutch auction, the auctioneer starts with a high price and continues to lower it until a bidder is found. When Google went public, it used a form of a Dutch auction to auction off its shares. In this bid, all bidders simultaneously submitted their bids and then the top bidders were awarded with stocks, until all stocks had been sold. However, while the CNN article "The ABCs of a unique IPO" reports this as a "Dutch Auction," it is really more similar to a sealed bid auction in that all bids were submitted simultaneously and the highest bids were able to buy stock. Somewhat similar to a second-price auction, all buyers were able to purchase at the lowest accepted bidders price, rather than at their bid amount. To read the article, go to http://money.cnn.com/2004/04/29/technology/googleauction/. By using this method, Google was attempting to avoid an increase in the price of stocks the first day of trading that would then rapidly decline, as other technology firms had seen. This type of auction is being called a “modified Dutch auction” and is becoming increasingly popular. The concept of the “modified Dutch auction” or “Dutch Auction IPO” is explained by investopedia.com. (http://www.investopedia.com/terms/d/dutchauction.asp#axzz1evqQNvio). Basically, in a Dutch Auction IPO, “potential investors enter their bids for the number of shares they want to purchase as well as the price they are willing to pay. Once all the bids are submitted, the allotted placement is assigned to the bidders from the highest bids down, until all of the allotted shares are assigned. However, the price that each bidder pays is based on the lowest price of all the allotted bidders, or essentially the last successful bid.” Strategically, Dutch auctions are the same as first-price, sealed-bid auctions and bidders should optimally behave the same in both auction types.
References & Links
Christie, Les. “The ABCs of a unique IPO.” Money.cnn.com. Apr. 29 2004. Web. <http://money.cnn.com/2004/04/29/technology/googleauction/>
“Dutch Auction.” Investopedia.com. Web. <http://www.investopedia.com/terms/d/dutchauction.asp#axzz1evqQNvio>
Week of 11/7/2011 – Advantages of Auctions
In this section, we will discuss why a buyer and a seller would prefer an auction. A company called "Walton and Associates" specializes in auctions, and on their website, they discuss some of the advantages of going to auction. According to Walton and Associates, "Auctions are the quickest and most efficient methods of selling goods at market value. The timeless simplicity of bringing buyers and sellers together in a live event goes back 1000's of years. The auction method of marketing allows buyers to attract sellers that are highly interested and highly qualified and allows them to compete for property." (http://www.waltonauctionsite.com/whyauction.html). Walton goes on to mention that auctions are a time-tested way to transition assets into cash, and that auctions are growing in popularity judging by their gross volume. One key driving benefit of an auction is that the time and terms of the sale are controllable by the seller. This is a large part of why auctions are so popular for government or business owned property, for example, a foreclosed home. The business would prefer a liquid asset, and by going to auction, they can set terms that the house be bought in cash and can set an auction date to ensure that the house is sold in a quick manner. This is also attractive to buyers, because investors able to meet the terms can often secure a better price than they would typically be able to get.
On the contrary, for unique items, auctions can also be beneficial to both parties but in a different way. When an item is rare or unique, it can be difficult for sellers to appropriately price and position the item to prospective buyers. By holding an auction, the item can be made available to all prospective buyers simultaneously and the seller is able to exchange the good with the buyer who has the highest reserve price and therefore values the item the most. This is advantageous for the buyer as well, because even if he may pay more for the item, he is able to purchase it when he otherwise might not have had the opportunity because another buyer who values the item less was able to get to the item first.
As discussed in each section, each type of auction also has specific advantages over other auction types. For example, according to Leslie Fine, the Dutch auction has the advantage of speed. (http://www.econlib.org/library/Enc/Auctions.html#abouttheauthor) Because bidding only continues until a bidder is willing to pay that price, these auction types are very quick. Fine suggests this is the primary reason why Dutch auctions are used for places such as flower markets in Holland. English auctions offer the advantage of allowing bidders to adjust their valuation as they gain additional information. This will be discussed in more detail in the section of this paper on information.
References & Links
Walton & Associates. “Why Auction.” Waltonauctionsite.com. Web. <http://www.waltonauctionsite.com/whyauction.html>
Leslie R. Fine, "Auctions." The Concise Encyclopedia of Economics. 2008. Library of Economics and Liberty. <http://www.econlib.org/library/Enc/Auctions.html>.
Week of 11/14/2011 – Disadvantages of Auctions
Of course, auctions also have disadvantages. First, not all auctions give the players in the auction the same amount of information. For example, in sealed-bid auctions, bidders do not learn of other bidders bids until it is too late to act on that information. Further, valuations are often based on personal taste and therefore difficult to estimate for other bidders. These concerns are best relieved for bidders by an English auction, where valuation of other bidders can be determined by their willingness to continue to bid. Bidders must be careful to ensure that they firmly understand their own reserve price prior to entering an auction to avoid overbidding due to the excitement of participating in the auction and wanting to "win." This is one scenario that can lead to the "Winner's Curse." According to Epiq Technologies, a supply management solutions company, the Winner's Curse occurs when "winning bidders... end up paying more for an item than it is truly valued at." (http://www.epiqtech.com/auction_software-Overview.htm). The Winner's Curse is more likely to occur when bidders have imperfect information. For example, if a bidder is bidding on artwork but is unsure of the authenticity, he may be subject to the winner's curse if he is overly optimistic.
As pointed out in the Epiq Technologies article, the other major disadvantage of auctions is collusion. There is incentive for both sellers and buyers to participate in collusive activity. For sellers, it would be advantageous to drive auction prices higher, and therefore there is incentive to collude with buyers who will artificially inflate the bid. This collusion is only effective in an English auction. In a sealed-bid auction, this information would not be available to other bidders in time for them to adjust. In a Dutch auction, the "planted" buyer would automatically win the auction.
Buyers also have incentive to collude in some auction structures. In particular, in a second-price sealed-bid auction, buyer collusion could drastically reduce the total amount paid for the item. By convincing the second place bidder to bid substantially less than the bidder's actual reserve price, the winning bidder can bid high without risk of actually having to pay that price. Epiq Technologies also discusses the concept of bidders agreeing to not outbid one another, and then later auctioning the item off amongst them. This too keeps prices lower but keeps the seller from receiving the fair value of the item.
References & Links
“Auction Overview.” www.epiqtech.com Web. <http://www.epiqtech.com/auction_software-Overview.htm>
Week of 11/21/2011 – Effect of Information on Auctions
The amount of information bidders have also directly effects which auction type is likely to be most profitable for the seller. According to Dr. Baye's book, Managerial Economics and Business Strategy, when buyer's bids are based on personal tastes, expected revenues will be basically equivalent for all auction types. In English auctions, bidders will only bid the small percentage necessary to beat the "second-bidder." In second-price auctions, the winning bidder will pay the price offered by the second-bidder. In Dutch auctions and first-price, sealed-bid auctions, the bidder will try to estimate the second-bidder price and bid as close as possible to that price. In each of these cases, the expected revenues are roughly equivalent to the valuation of the second bidder. However, valuations in some auctions are not solely based on personal preference. When values are strongly affected by the "real value" of the item, such as in the case of land, or when valuation is affected by the valuation of others, such as in artwork where valuation may increase the more others appreciate the artwork, the type of auction can impact the total revenues the auctioneer can expect to collect. In these cases, an English auction is likely to produce the highest revenues, followed by a second-price sealed bid auction. First-price sealed-bid auctions and Dutch auctions will remain equivalent to each other, and will produce the least revenues of the auction types. The main difference here is that bidders are working to avoid the Winner's Curse. To do this, they lower their own bid to only their personal valuation of the item and do not include other factors that may increase their willingness to pay. English auctions, by providing the bidders with on-going information about other players' bids, somewhat lessen the chance of the Winner's Curse and provide buyers with more information allowing them to increase their valuation. In a second-price auction, buyers only have to pay the price of the "second bidder," which also mitigates the Winner's Curse to some extent by providing the valuation of the next highest bidder, but it mitigates to a lesser degree than an English auction does.
A November 8 article in the Wall Street Journal discusses the power of information at an auction to help bidders determine their valuation and bid strategy. The article discusses the upcoming auction for the Los Angeles Dodgers. (http://online.wsj.com/article/SB10001424052970204554204577024294161309650.html?mod=googlenews_wsj). In the article, it says that “People familiar with the strategy say the more a bidder knows about his future revenues, the more comfortable he will be raising his bid.” Largely, bidders will base their valuations on information such as the current value of the local-media rights and what comparable items have auctioned for in the past. This information is readily available in the article. Knowing that the Dodgers “now get roughly $37 million a year from the deal” and that at action last year the Texas Rangers were purchased for $593 million is some of the information that will help prospective buyers to determine their offer.
References & Links
Futterman, Matthew. “Auction Plan Set for Dodgers.” Wall Street Journal. Nov.8 2011. Web. <http://online.wsj.com/article/SB10001424052970204554204577024294161309650.html?mod=googlenews_wsj>
Week of 11/28/2011 – Debt Auctions
One particular auction has been discussed frequently in the last week as the result of the auction is being used as a signal of the overall health of the European economy. One example of an article on this subject can be found at http://www.businessweek.com/ap/financialnews/D9R6JQ500.htm. According to the Business Week article, on November 23, Germany went to bond auction to sell 10-year bonds equivalent to $8.1 billion USD. The auction was met with only 60% demand and Germany was unable to sell all of the bonds that it planned to issue. As discussed previously, one advantage of auctions is the ability to quickly sell goods at market value and to best ascertain the market value of items by allowing buyers to provide their valuation of an item. In this case, the concern for the German and European economy is not the strict value of the money that Germany was unable to collect, but rather that the valuation of the bidders is lower than the reserve price on bonds. These bidders are behaving in an environment with imperfect information and must estimate the value of the bond. The valuation estimation is interesting in that the "real value" of the bond would be equal to an investor who purchased it - there is no "personal taste" factor in the valuation. However, bidders will each estimate the value of the bond independently, and, as seen in this example, are very likely to determine different valuations. In the case of bonds, investors base their valuation on facts like the issue price, time to maturity and yield, but they also base their valuation on their confidence in the government issuing the bond. Germany has long been recognized as the strongest economy in the Eurozone (the group of countries who use the Euro as their currency) and the lack of ability to sell 40% of the debt issued has many investors worried about the future of the Eurozone. Further reinforcing the concern, Italy also went to auction this week to sell bonds and, in order to sell all of the bonds issued, had to accept a record-breaking 6.5%. (http://www.reuters.com/article/2011/11/25/uk-italy-bonds-auction-idUKTRE7AO0EN20111125).
These examples of auctions of bonds show that auctions are not only an effective way to buy and sell items, but also an effective way to get information about the valuations of both buyers and sellers. This valuation information can then be used to determine behavior in other markets or to predict future changes. For example, after the failure of the bonds auction for Germany, stock prices worldwide went down as buyers reacted to the new information. Further, these auctions are leading many to speculate about the future of the Euro and how the Eurozone will recover from its ongoing debt crises.
References & Links
Baetz, Juergen and Casert, Raf. “Germany’s auction flop adds to European debt fears.” The Associated Press and Bloomberg Businessweek. Nov.23 2011. Web. <http://www.businessweek.com/ap/financialnews/D9R6JQ500.htm>
Za, Valentina. “‘Awful’ Italy debt sale heightens euro zone stress.” Reuters.com Nov. 25 2011. Web. <http://www.reuters.com/article/2011/11/25/uk-italy-bonds-auction-idUKTRE7AO0EN20111125>
Summary and Multiple Choice
Auctions, at their root, are a form of market to allow the buying and selling of goods and services. To review, in an auction "potential buyers compete for the right to own a good, service, or, more generally, anything of value." Auctions have been used for thousands of years, but are becoming increasingly popular and well-known, particular through the invention of online auction sites. Auctions can come in many various forms, but generally fall in to one of the main four auction types: English, first-price sealed-bid, second-price sealed-bid, or Dutch. An English auction is what most people typically think of when they hear “auction.” It involves buyers bidding continuously until the no bidder is willing to pay more than the final bid. A first-price, sealed-bid auction is quite different. Buyers are not privy to the bids of other bidders and are only able to bid once. A second-price sealed-bid auction, similar to a first-price sealed-bid auction, only allows buyers to bid once, but the winning bidder pays the price offered by the second-highest bidder instead of his own bid amount. Finally, a Dutch auction is the reverse of an English auction. Starting with high prices, an auctioneer continues to lower the price until a bidder offers to buy at that price. The bidder then wins the item at the price called.
In all of its forms, an auction can bring many key benefits to both buyers and sellers. Auctions tend to be quick ways to convert assets into cash, sellers can set the terms of the auction as they see fit, and market information about valuation can generally be ascertained without substantial loss to either the buyer or the seller in the form of surplus. However, auctions also can result in a “Winner’s Curse” when a buyer either has incomplete information or overbids his reserve price, and can provide incentive for buyers to collude or sellers to collude with buyers to capture more of the available surplus. The better the information available to all parties, the more likely an auction is to result in the advantageous outcomes and avoid the potential pitfalls of the auction model.
In the real world, we can see how understanding auctions, auction types and the advantages and disadvantages provides a better tool for understanding and predicting buyer and seller behavior in auctions. Specifically, we can see how the behavior in the German debt auction signals investor valuation of the market, and we can use that information to predict future market events such as a decline in stock prices worldwide, or the potential dissolution of the Eurozone. But, according to Paul Klemperer of Nuffield College in Oxford, England, the advantages to studying auction theory do not stop there. (http://www.nuff.ox.ac.uk/users/klemperer/VirtualBook/VirtualBookCoverSheet.asp) Klemperer argues that the basic tenets of auction theory can be applied to many various economic situations to better understand and predict the behavior of participants. Klemperer says that using the tools of auction theory, we can better understand complex situations “including litigation systems, financial crashes, queues, and wars of attrition.” Understanding auction theory is a critical tool in understanding more complex economic concepts.
References & Links
Klemperer, Paul. “Auctions: Theory and Practice” Oxford, England: Princeton University Press, 2004. Web. <http://www.nuff.ox.ac.uk/users/klemperer/VirtualBook/VirtualBookCoverSheet.asp>
Multiple Choice Questions
- As an auctioneer, you know that the item you are selling has a “real value” that is equivalent for all buyers. At which type of auction would you prefer to sell your item?
- Which of the following is not a disadvantage of auctions?
- What concerns investors most about the recent auction of German debt?
- What type of auction is typically used when businesses bid on a contract? a. English
Answer Keya. English
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
a. Seller’s incentive to collude in a English auction
b. Speed of selling items
c. Buyer’s incentive to collude in a second-price auction
d. Winner’s curse
a. Germany not receiving $26.25 billion USD it was hoping to gain from the sales
b. Apparent lack of confidence in the German economy
c. The slow sale of bonds
d. The lack of information about the quality of the bonds
You value an item at $100. You expect that 10 other people will bid on the item, and that they will value the item between $58 and $124. You are participating in a first-price, sealed-bid auction. What is your optimal bid?
a. $100.00
b. $58
c. $95.80
d. $91.00
You find out the auction will actually be a Dutch auction. What is your optimal bid now?
a. $100.00
b. $58
c. $95.80
d. $91.00
You also learn that the auction will now include 100 people. How does your optimal bid change?
a. It increases
b. It decreases
c. It stays the same
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
What makes a contract bid auction unique from most other types of auctions?
a. It always involves only 2 bidders
b. The seller is always a government agency
c. The winning bidder generally bids the lowest price
d. It is not different
- As an auctioneer, you know that the item you are selling has a “real value” that is equivalent for all buyers. At which type of auction would you prefer to sell your item?a. English
An English auction is likely to produce the highest possible revenues, because buyers can continue to re-evaluate their valuation of the item as the compare it against others valuation and adjust their bid accordingly. They are less likely to suffer from the “Winner’s Curse” and are therefore more likely to continue to bid until their maximum willingness to pay is reached.b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
a. Seller’s incentive to collude in a English auction
b. Speed of selling items
c. Buyer’s incentive to collude in a second-price auction
d. Winner’s curse
The speed with which items can be sold is an advantage of auction models. In an English auction, sellers would be incentivized to collude with buyers to artificially raise the bids to capture additional surplus. In a second-price auction, buyers have incentive to collude to ensure they both win the item and reduce the amount that they must pay for it. The “Winner’s Curse” occurs when the valuation a bidder placed on the item turns out to be higher than their actual value for the item.
a. Germany not receiving $26.25 billion USD it was hoping to gain from the sales
b. Apparent lack of confidence in the German economy
c. The slow sale of bonds
d. The lack of information about the quality of the bonds
The lack of confidence in the German economy evidenced by the low valuation of German bonds is what has analysts most concerned about the Auction failure. All other factors, such as the number of bonds Germany was unable to sell, are being interpreted more as signals to the overall health of and confidence in the German and European economies.
a. $100.00
b. $58
c. $95.80
d. $91.00
Using the formula b = v - ((v-L) / n), you find that your optimal bid is $95.80. (v=$100, L=$58, n=10)
You find out the auction will actually be a Dutch auction. What is your optimal bid now?
a. $100.00
b. $58
c. $95.80
d. $91.00
Dutch auctions and first-price, sealed-bid auctions use the same strategy, so your bid will be the same.
You also learn that the auction will now include 100 people. How does your optimal bid change?
a. It increases
b. It decreases
c. It stays the same
As the number of people increases, your optimal bid will become closer to your valuation.
a. English
b. Dutch
c. First-price sealed-bid
d. Second-price sealed-bid
Contract bids normally are conducted as first-price sealed-bid auctions. Companies competing may not even know the number of bidders involved.
What makes a contract bid auction unique from most other types of auctions?
a. It always involves only 2 bidders
b. The seller is always a government agency
c. The winning bidder generally bids the lowest price
d. It is not different
Because bidders are bidding to provide services rather than buy them, the winning price is generally the lowest cost that provides the services required.