Auctions aren’t that simple. Are they?
Solving the Auction Maze Auction plays an impeccable role in distributing scarce resources and power for efficiency and management purposes. This branch of economics, the Auction theory, studies extensively on ‘the right price’ of a product that is being auctioned. To illustrate this, let’s analyse a situation. Most of the products that we buy have fixed prices. What if a particular product/ investment had a limited nature and a large number of people were interested in it? How can we come up with a final price?
The auction here helps determine how seriously someone wants something. But is it that complicated to be studied and given the Sveriges Riksbank Prize in Economic Sciences in the memory of Alfred Nobel (yes, it isn’t technically a Nobel prize)? Before entering into the technical part, let’s understand why the ‘right price’ concept is important. A low auction price for buying/ leasing service can provide service to the public with low cost and low standards. On the other hand, when the winning price is way above the intrinsic value, the price for the service is high, which in turn reduces the consumer satisfaction. Often the second-highest bid would differ by a huge sum. If the second-highest number/ the actual price were known through some estimations, the winning bid would have differed by a small amount (in other terms, it wouldn’t have been overpriced). This is called the winner’s curse, where the winning bid is much higher than the second-highest bid. On top of all, human psychology and hidden information, an essential factor playing in auctions, can be extremely complicated to incorporate in general assumption. This makes the study indispensable for a profitable business and for overall satisfaction.
Auction theory studies how auctions are designed, rules governing them, how bidders behave and its respective consequences.
The main factors that are taken into account include
1. Rules of the Auction – Different sets of rules are formulated depending on the type of auction (English or Dutch Auction – the difference is that the former one is transparent where bidders have complete information of others’ value and the latter one is where each bidder submits bidding value in a sealed envelope), single-unit or multi-unit bids (assume a situation where the company is being auctioned. If it’s being sold as a single unit its called single-unit bidding whereas if it is segmented into different components such as machinery, workspace, logistics etc. are being considered as a separate unit, it is termed as multi-unit bidding)
2. Commodity or Service being auctioned – A large variety of commodities and services are being auctioned on a day to day basis. For public/ common commodities such as steel, coal, iron ore, metals, telecom spectrum, bidding price estimation can be less complex. On the other hand, items such as sculptures, paintings, historical souvenirs etc., price estimation can be extremely difficult. For such items, a reserve price is set by the seller before the auction to motivate bidders. In common value model, the actual value is same for everyone, but some bidders have additional private information, i.e. if a house is up for auction, each person values it based on common information along with few additional personal desire, whereas in the private value model, each bidder sees the product’s value with private information meaning, if an oil field is up for auction, with the private information of new technological products, each person’s bid value will be based on their info. Almost all auctions are a combination of both the models.
3. Uncertainty – You would have come across the term human psychology, a few paragraphs above which talks about the mindset of bidders. This is an important factor to determine the outcome of the auction. Bidders are often distressed by the possibility of others knowing additional info about the object which might lead the others to the right price or by the thought of them ending with the winner’s curse. Bidders often collude to lower the final price of the object being auctioned. Though considered illegal, they are extremely difficult to monitor.
What were the improvements made?
Robert Wilson was the first to create a framework for the analysis of auctions with common values. He showed that rational bidders tend to place bids lower than their actual estimate due to the fear of ‘winner’s curse’ and its effect increases with increase in uncertainty. He also showed that the effects due to the winner’s curse are worse when some bidders have private information.
Paul Milgrom proposed a general theory of auctions which applies to both private and common values. He also showed that the seller’s revenue increases when private information is made available to the bidders before the start of the auction. He has also made his contribution in setting up new kinds of auctions to reduce the effect of collusion and improve seller’s revenue. Milgrom, along with other economists including Robert Wilson and Preston McAfee, played a major role in designing the simultaneous multiple round auctions which were adopted by the Federal Communications Commission (FCC).
In the end, the sellers always hope for a higher bid, and the bidders always hope for a lower price. But their work will always be greatly beneficial to society as a whole.
Akash
