An Introduction to Auction Theory
Auction theory is the study of auctions using the principles of economics and game theory, specifically analyzing the decision-making process for participants and the theoretical properties of different auctions. Since there are many designs for auctions, some more familiar than others, auction theory seeks to compare the efficiency of auction designs, bidding strategies and price differences.
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Types
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There are four basic auction types, although variations on these four exist. An English auction is most familiar to an American citizen. The price steadily rises, as the auctioneer collects higher and higher bids, dropping bidders as the price continues up. When only one bidder remains, the item is sold for the current price. In a Dutch auction, also called an open descending-bid auction, the reverse happens. The price of the item is set high and gradually lowered; the first bidder to bid wins, and pays the current price. These two types of open auctions stand in contrast to sealed-bid auctions. In a first-price sealed bid auction, all bidders secretly submit their bids, and the highest bidder wins. In a second-price sealed bid auction, the same thing happens, except the highest bidder wins but pays the amount of the second-highest bid.
Private-Value Auctions Versus Common-Value Auctions
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Besides these four general structures of auctions, auctions can either be private-value or common-value auctions. In a private-value auction, the price of the item to be sold is variable and subjective, such that each bidder knows his or her reservation price, the maximum amount the individual is willing to pay, but he or she doesn't know what the other's reservation prices are. This would be the case for an art auction---some might be willing to pay top dollar for a certain piece of art, while someone else might not pay much. In a common-value auction, on the other hand, the item at stake has about the same value to all bidders, even though bidders do not know precisely what that value is. For example, a oil company bidding for offshore drilling rights knows that the value of the rights will relate to the amount of oil in the ground, but the amount of oil in the ground is uncertain.
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Comparing Auction Types: Private-Value Auctions
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For private-value auctions, auction theory suggests that all of these auctions yield similar results. For the English auction and the second-price sealed bid auction, the bidder's strategy will always be to bid their reservation price (or up to it, for an English auction). By bidding the highest price they'd be willing to pay, even in the case of the second-price sealed auction, the bidder will come out with a successful transaction (one where they pay equal to or less than their reservation price for the good). For first-price sealed bid auctions, the best bidding strategy is not to bid the reservation price, but is to chose a bid that will be equal or slightly more than the reservation price of the bidder with the second-highest reservation price (because the winner pays his bid, and it is never worth paying more than the second-highest reservation price). However, economists have reason to believe that the four major auction types, when used for private-value auctions, yield comparable results for both buyers and sellers.
Comparing Auction Types: Common-Value Auctions
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Common-value auctions require different strategies from the bidder's perspective, as the value of the item can be determined by the market. Since the winner of the auction is the highest bidder, one common phenomena in common-value auctions is the "winner's curse." The winner's curse is a situation where the winner of a common-value auction is worse off as a consequence, by overestimating the value of the item and therefore overbidding. For example, if you and a few friends decide to play a game and bid on a jar of pennies, the bids might be $5, $8, $9 and $11. If the actual value of the pennies is $10, the highest bidder "wins" the transaction, and pays $11 for $10 worth of pennies for a net loss of $1. One way to avoid the winner's curse in common-value auctions is to account for the fact that your estimate of the value is subject to error. Firms that engage in common-value auctions frequently (like oil companies) use statistical methods to account for this behavior.
Maximizing Your Seller's Revenue
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From the viewpoint of the seller, auctions are designed to get the most revenue for the sale of ownership of your asset. There are several methods to increase your revenue. In a private-value auction, encourage as many bidders as possible (the more bidders, the higher the expected bid of the winning bidder and/or second-highest bidder). Also, set a minimum bid equal to or higher than the value to you of keeping the item for future sale, so as not to lose on the deal should the bidding be sparse. For common-value auctions, use open rather than sealed-bid auctions to generate more revenue. Also, reveal as much information as possible about the object, which reduces concern about the winner's curse and therefore encourages more bidding.
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References
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