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Auction Markets Jon Levin Winter 2010 Economics 136.

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1 Auction Markets Jon Levin Winter 2010 Economics 136

2 Multi-Unit Auctions

3 Examples Treasury auctions Auction-rate securities IPO auctions Privatization Electricity markets Asset sales Condominium sales Wine/Art/Antiques Auto auctions Natural resources Radio spectrum Emissions permits Airport landing slots Bus routes Procurement contracts Sponsored search Internet display ads eBay marketplace

4 Sequential auctions Auction houses often sell identical goods sequentially (e.g. lots of wine). What happens at sequential auctions? Should you bid your value in the first auction? Are early prices higher or lower than later prices?

5 Sotheby Wine Auctions Source: Ashenfelter (1989, Journal of Economic Perspectives)

6 Declining Prices

7 A puzzle? Standard theory: in a symmetric private value setting, prices need not be equal across sequential first or second-price auctions, but… Webers Theorem. Equilibrium prices should follow a random walk: E[p t+1 |p 1 …p t ]=p t Yet the declining price anomaly appears to be quite robust – wine, art, cattle, etc – and variants observed with non-identical items. This remains something of an open puzzle.

8 Simultaneous Sales of Identical items Consider auction for k identical items. Possible one-shot auction methods Uniform price (clock and sealed bid) Discriminatory price (pay-your-bid and Vickrey). We will see that one important issue is whether bidders want just one item, or are potentially interested in winning several items.

9 Uniform price auctions Sellers often want to run an auction in which all winners pay the same uniform price. Perceived as fair; achieves price discovery Uniform price formats Clock auction: seller announces a sequence of prices and bidders name quantities until a market-clearing price is found and auction ends. Sealed bidding: participants bid a price-quantity schedule and bids are used to determine the uniform market-clearing price.

10 British CO 2 Auctions Greenhouse Gas Emissions Trading Scheme Auction, United Kingdom, UK government aimed to spend 215 million British pounds to get firms reduce CO 2 emissions. Clock auction used to determine What price to pay per unit? Which firms to reward?

11 Greenhouse Auction Rules Auctioneer calls out price Price starts high and decreases each round. Each round, bidders state tons of CO 2 they will abate Tons abated can only decrease as prices decrease. Auctioneer multiplies tons of abatement times price. If total cost exceeds budget, lowers the price When total cost first falls short of budget, auction ends and that allocation is implemented Auction results 38 bidders (34 winners), 4m metric tons of CO 2 reduction. Price per metric ton: £215m/4m= £53.75

12 Graphical treatment Q P UK Demand Curve, defined so that Q*P(Q)=£215m p1p1 p2p2 p* Falling prices trace out a supply curve.

13 Sealed bid version Uniform-price sealed bid auction Auctioneer posts its demand curve Bidders submit supply curves - i.e. how much they will supply at each price. Individual supply curves are aggregated to form an aggregate supply curve. Price is set so that supply = demand.

14 Strategic equivalence? Are clock and sealed auctions strategically equivalent? Suppose bidders in the clock auction observe only the prices and that prices decline in a fixed sequence. Bidders are then effectively being asked to reveal their supply curves from the top down, with no new information each round other than that the current price is relevant. So yes, the clock auction is strategically equivalent to a sealed bid auction in which supply curves get written down in advance. Equivalence may fail if more information is revealed each round.

15 Incentives with Uniform Price Suppose each bidder wants a single item. Values are drawn from U[0,1]. n bidders, k items with n>k. Bidders submit bids: price = k+1 highest bid. Theorem. For a bidder with single item demand, it is a dominant strategy to bid ones value. Proof. Similar to the second price case.

16 Demand reduction Example: three items for sale Bidder 1: value 120 and wants 1 item. Bidder 2: value 110 and wants 1 item. Bidder 3: value 100 and wants 1 item. Bidder 4: value 105 and wants 2 items. Consider what happens with truthful bidding Bids are 120, 110, 105, 105, 100. Three highest bids are winners Fourth highest bid is 105 => winners pay 105 each.

17 Demand reduction Example: three items for sale Bidder 1: value 120 and wants 1 item. Bidder 2: value 110 and wants 1 item. Bidder 3: value 100 and wants 1 item. Bidder 4: value 105 and wants 2 items. Demand reduction by bidder 4 If he bids 105, he wins 1 item and pays 105. If he bids 101, bids are 120, 110, 101, 101, 100. He still wins 1 and lowers the price to 101!

18 Example, cont. Again, three items and values Bidder 1: 120 Bidder 2: 110 Bidder 3: 100 Bidder 4: 115 and wants two units. Demand reduction by bidder 4 Bid 115 for both units => wins two, price =110. Bid 115 for first unit, 100 for second => wins 1, p=100. Bidder four optimally exercises market power.

19 Demand Reduction Picture Q P b1b1 Supply Q=3 3 b2b2 b3b3 b4b4 Opponent Bids and demand curve Residual supply curve Multi-unit bidder wants to maximize profit by behaving as a monopsonist against the residual supply curve.

20 Low Price Equilibrium Q P Supply 3 Residual supply curve in a regular equilbrium Residual supply curve in a low price equilibrium Residual supply curve if seller adds elasticity Expanded supply

21 Multi-Unit Auctions and Financial Assets

22 Todays Lecture Uniform price sealed bid auctions Virtues: simple, fair, reveal market price Concerns: demand reduction, low price eqm Comparison to alternatives Discriminatory price auctions Vickrey auction Application to financial markets Extensions to multiple goods

23 Uniform-price sealed bid auction Auctioneer posts its supply curve Bidders submit demand curves - i.e. how much they want at each price. Individual demand curves are aggregated to form an aggregate demand curve. Price is set so that supply = demand Demands at the market clearing price are satisfied.

24 Incentives with Uniform Price N bidders, K items with N>K Each bidder wants one unit, values U[0,1]. Bids submitted (offer to buy one unit at some price) Market clearing price = any price between the kth highest bid and the K+1th highest bid (why?) Assume lowest clearing price: K+1 highest bid. Theorem. For a bidder with single item demand, it is a dominant strategy to bid ones value. Proof. Similar to the second price case. Theorem is not true if bidders want multiple units (next slide!)

25 Demand reduction Example: three items for sale Bidder 1: value 120 and wants 1 item. Bidder 2: value 110 and wants 1 item. Bidder 3: value 100 and wants 1 item. Bidder 4: value 105 and wants 2 items. Consider what happens with truthful bidding Bids are 120, 110, 105, 105, 100. Three highest bids are winners Fourth highest bid is 105 => winners pay 105 each.

26 Demand reduction Example: three items for sale Bidder 1: value 120 and wants 1 item. Bidder 2: value 110 and wants 1 item. Bidder 3: value 100 and wants 1 item. Bidder 4: value 105 and wants 2 items. Demand reduction by bidder 4 If he bids 105, he wins 1 item and pays 105. If he bids 101, bids are 120, 110, 101, 101, 100. He still wins 1 and lowers the price to 101!

27 Example, cont. Again, three items and values Bidder 1: 120 Bidder 2: 110 Bidder 3: 100 Bidder 4: 115 and wants two units. Demand reduction by bidder 4 Bid 115 for both units => wins two, price =110. Bid 115 for first unit, 100 for second => wins 1, p=100. Bidder four optimally exercises market power.

28 Demand Reduction General model N bidders, K items, where 2 k

29 Low price Equilibria With fixed supply, uniform price auction can have equilibria with low prices due to demand reduction. Example: three units, three bidders. Bidders value units at 10, want as many as possible. The price should be 10 if there is competition. What if each bidder offers to buy one unit for 10, and no additional units at any price above zero. Bidders split the units, price is zero! Because a bidder who wants to purchase additional units has to pay ten, there is no reason to demand more. The low price bidding is a Nash equilibrium!

30 Making supply elastic Suppose the seller offers To sell 3 units at any price To sell 4 units if (and only if) price exceeds 4 Claim: Any Nash equilibrium for bidders involves selling four units at a price of at least 4. If bidders bid (10,0), each bidder gets 1 unit, p=0. Each bidder has incentive to bid (10,4) => win two units and price increases to four. Profit of 2*(10-4)=12>10. Equilibrium will have one bidder winning two items, and fifth highest bid somewhere between 4 and 10. Somewhat surprisingly, seller has managed to increase supply and yet also increase prices.

31 California electricity crisis The California electricity crisis of 2001 Prices go from around $45 megawatt-hour to as high as $1400. Paul Joskow of MIT: California electricity crisis is what happens when a vertical supply curve intersects a vertical demand curve. Steep supply/demand: during the crisis a 5% lowering of demand (or increase in supply) would have lowered prices by 50%! Borenstein, Bushnell, Wolak (AER, 2003): vertical demand because consumers dont react to price, vertical supply because generators strategically withhold power. Remedies? Create elasticity in electricity demand (how?). Restrict slope of submitted supply curves. Encourage build-out of additional capacity (how?). Forward contracts (unravel the market!).

32 Increasing Returns… Discussion implicitly focused on bidders with decreasing marginal values who submit downward- sloping demand curves. What if there are scale economies? Two units for sale Bidder 1 offers 10 for one unit. Bidder 2 offers 5 for first unit and 11 for second. There is no uniform price that clears the market! Not much is known about performance of uniform price auctions where there are scale economies.

33 Expanding the example… Two units for sale Bidder 1 offers 10 for one unit. Bidder 2 offers 5 for first unit and 11 for second. Consider possible prices At p < 8, demand = 3 At p = 8, demand = 1 or 3 At p in (8,10), demand = 1 At p = 10, demand = 0 or 1 At p > 10, demand = 0 Problem: demand crosses supply at price = 8, but at that price, Bidder 1 demands 1, and Bidder 2 demands 0 or 2 but is unwilling to buy 1! So cant have demand=supply!!!

34 Discriminatory Price Auctions Alternative is a pay-your-bid format Bidders submit bids (offers to buy different quantities at different prices) Seller finds price where supply=demand All bids above clearing price are satisfied, but winners pay their bid rather than the clearing price.

35 Example Example: three items for sale Bidder 1: value 120 and wants 1 item. Bidder 2: value 110 and wants 1 item. Bidder 3: value 100 and wants 1 item. Bidder 4: value 105 and wants 2 items. Suppose truthful bids Bidder 1: (1, 120) buy one at any price < 120 Bidder 2: (1, 110) Bidder 3: (1, 100) Bidder 4: (2, 105) Outcome: 1, 2, 4 win and pay 120, 110, 105. Is this an equilibrium? Why or why not?

36 Example, cont. Example Bidders 1, 2, 3 want 1 item and values 120, 110, 100. Bidder 4: wants two items and value 105. Possible equilibrium bids? Bidder 1: (1, 105) Bidder 2: (1, 105) Bidder 3: (1, 100) Bidder 4: (2, 105) So 1, 2, 4 win and all pay 105. Is this an eqm? Why or why not?

37 Example, cont. Example Bidders 1, 2, 3 want 1 item and values 120, 110, 100. Bidder 4: wants two items and value 105. Possible equilibrium bids? Bidder 1: (1, penny) Bidder 2: (1, penny) Bidder 3: (1, 100) Bidder 4: (2, penny) So 1, 2, 4 win and all pay penny. Is this an eqm? The actual equilibrium involves mixed strategies with bids distributed between 100 and 105!

38 Uniform vs. Discriminatory Both auctions can be inefficient. Both auctions create an incentive to reduce demand if bidders want multiple units. Does one lead to higher prices? Not clear in general. Does one lead to higher or lower participation or reveal more useful information? Sometimes argued that uniform price auction is good for small bidders b/c its easy to participate and get the market price, but discriminatory price can sometimes be painful for large high-value bidder.

39 US Treasury Experience US Treasuy historically ran discriminatory auctions (since the 1970s) to sell bonds. Beginning in 1992, switched to uniform price. Rationale Aim for more liquid market (transparency) Encourage broader participation Encourage competition (slightly vague) Features of the market: large, highly liquid There is some price impact from the new issuance. There is also a when-issued market that runs prior to the auction, so participants can guage likely price. Many participants (75-85 bidders), but relatively small number of primary dealers win a lot of the bonds.

40 Treasury experience, cont. Evidence from US transition Switch to uniform price led to somewhat lower spread between auction price and WI price (but not very large or stat. significant). Somewhat more volatility between auction price and WI price b/c more dispersed bids w/ uniform price auction. Awards to primary dealers similar under the two types of auctions, but share of awards to the very top dealers decreased with uniform price. Debate in other countries: possible that design may matter more if market is thinner or less transparent.

41 TARP Warrant Auctions As part of TARP, Treasury received warrants from banks that were bailed out Warrants give holder a right to buy the stock at some strike price at any point over the next 10 years. Like an option except that when a warrant is exercised, the firm issues new shares rather than buying back shares (so there is dilution) Treasury negotiated with banks to sell them back the warrants but some negotiations failed, leaving treasury to dispose of the warrants. Question: how to design an auction to sell the warrants?

42 Warrant auctions, cont. Questions one must address Uniform price or discriminatory? Sell all warrants at once, or over time? Sealed bid or ascending auction? Potential for a winners curse Treasury (via auction agent) decided on a standard treasury format, ran three in fall. Evidence from JPM auction (largest at $1 bn) suggests a large price impact (auction price 30% below subsequent after-market price. Now treasury must consider whether this was a big number, and whether to change the design. What data would you want to look at?

43 An Efficient Auction? Back to our example with three items for sale Bidder 1: value 120 and wants 1 item. Bidder 2: value 110 and wants 1 item. Bidder 3: value 100 and wants 1 item. Bidder 4: value 105 and wants 2 items. Is there a pricing rule that would make it a dominant strategy for each bidder to bid truthfully – and would lead to an efficient allocation of the items?

44 Vickrey Prices Set price for each bidder equal to the value per unit the bidder displaces. Equivalently: use submitted values to compute total value with and without the bidder present. Set price for the bidder so that his profit equals the value he creates. Vickrey pricing makes bidding truthfully a dominant strategy. But Vickrey prices are not uniform prices!

45 Vickrey pricing Example: three items for sale Bidder 1: value 120 and wants 1 item. Bidder 2: value 110 and wants 1 item. Bidder 3: value 100 and wants 1 item. Bidder 4: value 105 and wants 2 items. Vickrey pricing if truthful bids Bidders 1 and 2 win, pay 105 each (displace 4). Bidder 4 wins one unit, pays 100 (displaces 3).

46 Vickrey pricing, again Example: three items for sale Bidder 1: value 120 and wants 1 item. Bidder 2: value 110 and wants 1 item. Bidder 3: value 100 and wants 1 item. Bidder 4: value 115 and wants 2 items. Vickrey pricing if truthful bids Bidder 1 wins and pays 110 (displaces bidder 2). Bidder 4 wins two units, pays 100 for first unit (displaces bidder 3) and 110 for second (displaces bidder 2).

47 General Lessons Uniform price auctions have fairness, transparency virtues But encourage demand reduction when bidders want multiple units Also create the possibility of low price collusive seeming equilibria (making supply elastic can help with this problem). Discriminatory price auctions also encourage demand reduction, but sometimes viewed as a way to raise revenue from high value bidders – although revenue implications generally unclear. Vickrey pricing can eliminate demand reduction and restore efficiency, but the uniform price property is lost.

48 Multi-Item Auctions and Matching

49 Multiple Kinds of Goods Can we design successful auctions that allow for multiple kinds of goods? Spectrum licenses covering different cities. Electricity delivered from/to different places. Multiple kinds of financial assets. Emissions reductions in different years. Different kinds of sponsored search placements.

50 General issues What would be desirable properties? Auction finds market clearing prices (uniform price) Auction is strategyproof (Vickrey), or nearly so. Auction is relatively simple, robust to collusion, etc. The challenge Bidder preferences may be complex and complex preferences are hard to state in sealed bid auction. Complementarities (like increasing returns) may imply that market clearing prices dont exist. Auction complexity and strategy can be serious issues.

51 Connection to matching There is a connection to matching theory… Treat bidders as one side of the market Treat items for sale as the other side We are interested in a matching (for now, one-to- one, but potentially many-to-one). But now we have to determine prices as well as the assignment.

52 Deferred acceptance? Each bidder submits a preference list Example: first choice is to pay zero for item 1, second choice is to pay $1 for item 1, third choice is to pay $0 for item 2, fourth choice is to pay $2 for item 1, etc.. Seller runs deferred acceptance algorithm Bidders propose to the items. Items prefer to sell for more money, accept highest offer. Algorithm will eventually terminate.

53 Auctions & Matching Ascending auction (Kelso & Crawford, 1982) Bids made by computer. 1. Bidders offer most preferred remaining acceptable purchase. 2. Items hold best bid, reject others. 3. Rejected bidder strikes offer from his/her list. 4. Process continues until no new offers or rejections. 5. Implement last held allocation. Matching algorithm (Gale & Shapley, 1962) Offers made by computer. 1. Doctors apply to most preferred remaining acceptable program. 2. Hospitals hold best doctor, reject others. 3. Rejected doctor strikes the hospital from his/her list. 4. Process continues until no new offers or rejections. 5. Implement last held allocation.

54 Deferred acceptance auction What we know from matching theory Suppose bidders are each interested in a single item. Algorithm will converge to a stable allocation. Bidder-offering auction is strategy-proof for the bidders. Connection to auctions/markets Stability: at the deferred acceptance final price for each item, there is exactly one bidder, so supply = demand! A stable allocation is a competitive equilibrium Strategy-proof: the competitive equilibrium prices are the same as one would get from a Vickrey auction! Extension to multi-good demand?

55 Sponsored Search Auctions

56 Google revenue in 2008: $21,795,550,000. Hal Varian, Google chief economist: What most people dont realize is that all that money comes pennies at a time. Today well discuss internet keyword auctions. References: Varian 2008, Edelman et al

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60 Keyword Auctions Advertiser submit bids for keywords Offer a dollar payment per click. Alternatives: price per impression, or per conversion. Separate auction for every query Positions awarded in order of bid (more on this later). Advertisers pay bid of the advertiser in the position below. Generalized second price auction format. Some important features Multiple positions, but advertisers submit only a single bid. Search is highly targeted, and transaction oriented.

61 Brief History of Sponsored Search Auctions Pre-1994: advertising sold on a per-impression basis, traditional direct sales to advertisers. 1994: Overture (then GoTo) allows advertisers to bid for keywords, offering some amount per click. Advertisers pay their bids. Late 1990s: Yahoo! and MSN adopt Overture, but mechanism proves unstable - advertisers constantly change bids to avoid paying more than necessary. 2002: Google modifies keyword auction to have advertisers pay minimum amount necessary to maintain their position (i.e. GSP)- followed by Yahoo! and MSN.

62 Example Two positions: receive 200 and 100 clicks per day Advertisers 1,2,3 have per-click values $10, $4, $2. Efficient allocation Advertiser 1 gets top slot: value created 200*10 = 2000 Advertiser 2 gets 2 nd slot: value created 100*4 = 400 Total value creation: $2400

63 Example: competitive eqm Two positions: receive 200 and 100 clicks per day Advertisers 1,2,3 have per-click values $10, $4, $2. Competitive equilibrium Set prices for slots (p 1, p 2 ) so that demand = suppy Example: p 2 = 2 and p 1 = 4 Advertiser 3 demands nothing Advertiser 2 demands slot 2: 100*(4-2)>200*(4-4)=0 Advertiser 1 demands slot 1: 200*(10-4)>100*(10-2) Efficient outcome with revenue: $800+$200= $1000

64 Example: competitive eqm Two positions: receive 200 and 100 clicks per day Advertisers 1,2,3 have per-click values $10, $4, $2. Many possible mkt-clearing prices (p 1, p 2 ) Advertiser 3 must demand nothing, so p 1, p 2 2 Advertiser 2 must demand slot 2, so p 2 4, and 2p 1 - p 2 4 (so that 200*(4- p 1 ) < 100*(4-p 2 ) ) Advertiser 1 must demand slot 1, so 2p 1 - p 2 10 (so that 200*(10- p 1 ) < 100*(10-p 2 ) ) Allocation efficient with revenue: 200p p 2

65 Competitive Eqm p2p2 p1p Possible competitive equilibrium prices! Can we use an auction to find these prices?

66 Example: Pay-your-Bid Two positions: receive 200 and 100 clicks per day Advertisers 1,2,3 have per-click values $10, $4, $2. Overture auction (pay your bid) Advertiser 3 will offer up to $2 per click Advertiser 2 has to bid $2.01 to get second slot Advertiser 1 wants to bid $2.02 to get top slot. But then advertiser 2 wants to top this, and so on. Pay your bid auction is unstable!

67 Overture bid patterns Edelman & Ostrovsky (2006): sawtooth pattern caused by auto-bidding programs.

68 Overture bid patterns, cont.

69 Vickrey Auction Bidders submit bids (price per click) Auctioneer treats bids as values Finds allocation that maximizes value created So high bid gets top slot, and so forth Vickrey payment for bidder j Note that if bidder j gets a slot, he is displacing other bidders by moving them down a slot. Compute the lost value from this displacement (e.g. if j pushes k down a slot, k loses clicks that are worth some amount to k) Bidder js payment equals total displacement cost, or equivalently the externality j imposes on other bidders.

70 Vickrey Auction, cont. Second price auction is a Vickrey auction Winner displaces second highest bidder Winner pays the displaced value: 2 nd high bid Also a Google auction with one click for sale! General properties of Vickrey auction Dominant strategy to bid truthfully (bid = value)! Outcome is efficient (maximizes total value)!

71 Vickrey auction, aside Recall our example with three items for sale Bidder 1: value 120 and wants 1 item. Bidder 2: value 110 and wants 1 item. Bidder 3: value 100 and wants 1 item. Bidder 4: value 105 and wants 2 items. Vickrey pricing if truthful bids Bidders 1 and 2 win, pay 105 each (displace 4). Bidder 4 wins one unit, pays 100 (displaces 3).

72 Example: Vickrey auction Two positions: receive 200 and 100 clicks per day Advertisers 1,2,3 have per-click values $10, $4, $2. Vickrey auction Advertisers are submit bids, assigned efficiently given submitted bids, and have to pay the value their ad displaces. Dominant strategy to bid ones true value. Vickrey outcome Advertiser 1 gets top, then 2, and 3 gets nothing. Adv. 2 pays $200 (displaces 3) for 100 clicks, or $2 /click. Adv. 1 pays $600 (displaces 3 & 2) for 200 clicks, $3 /click. Efficient allocation with revenue of $800.

73 Deriving the Vickrey prices Two positions: receive 200 and 100 clicks per day Advertisers 1,2,3 have per-click values $10, $4, $2. Vickrey payment for Bidder 2 Bidder 2 displaces 3 from slot 2 Value lost from displacing 3: $2 * 100 = $200 So Bidder 2 must pay $200 (for 100 clicks), or $2 per click. Vickrey payment for Bidder 1 Displaces 3 from slot 2: must pay $200 Displaces 2 from slot 1 to 2: must pay $4*( )=$400 So Bidder 1 must pay $600 (for 200 clicks), or $3 per click. Vickrey prices are therefore p 2 = 2 and p 1 = 3, revenue $800.

74 Vickrey prices p2p2 p1p Vickrey prices are the lowest competitive equilibrium prices! Vickrey prices

75 Google GSP Auction Generalized Second Price Auction Bidders submit bids (per click) Top bid gets slot 1, second bid gets slot 2, etc. Each bidder pays the bid of the bidder below him. Do the bidders want to bid truthfully?

76 Truthful bidding? Not a dominant strategy to bid truthfully! Two positions, with 200 and 100 clicks. Consider bidder with value 10 Suppose competing bids are 4 and 8. Bidding 10 wins top slot, pay 8: profit = 400. Bidding 5 wins next slot, pay 4: profit = 600. If competing bids are 6 and 8, better to bid 10…

77 Example: GSP auction Two positions: receive 200 and 100 clicks per day Advertisers 1,2,3 have per-click values $10, $4, $2. Generalized Second Price Auction In this case, it is an equilibrium to bid truthfully Bidder 2 gets slot 2 and pays $2 per click (or $200) Bidder 1 gets slot 1 and pays $4 per click (or $800) Efficient allocation, revenue is $1000 (> Vickrey!) Why an equilibrium? Bidder 3 would have to bid/pay $2 to get slot 2 – not worth it. Bidder 2 would have to bid/pay $10 to get slot 1 – not worth it. Bidder 1 could bid/pay $2 and get slot 2, but also not worth it.

78 GSP equilibrium prices p2p2 p1p GSP prices are also competitive equilibrium prices! Vickrey prices GSP eqm Not the only GSP equilibrium, however

79 Example: GSP auction Two positions: receive 200 and 100 clicks per day Advertisers 1,2,3 have per-click values $10, $4, $2. Another GSP equilibrium (with Vickrey prices!) Bidder 3 bids $2 and gets nothing Bidder 2 bids $3 and pays $2 per click for slot 2 Bidder 1 bids $10 and pays $3 per click for slot 1 And another GSP equilibrium (w/ higher prices) Bidder 3 bids $3 and gets nothing Bidder 2 bids $5 and pays $3 per click for slot 2 Bidder 1 bids $6 and pays $5 per click for slot 1

80 GSP equilibrium prices p2p2 p1p GSP equilibrium prices are also competitive equilibrium prices! Vickrey prices GSP eqm

81 General Model K positions k=1,..,K N bidders i = 1,…,N Bidder i values position k at u ik = v n x k x k is quantity of clicks, x 1 >x 2 >…>x K v n is value of a click, v 1 >v 2 >…>v K Efficient allocation is assortative Bidder k should get slot k to max total value.

82 GSP Auction Rules Each agent i submits bid b i Interpret as maximum amount i offers to pay per click Positions assigned in order of bids Agent is price per click is set equal to the bid of agent in the next slot down. Let b k denote kth highest value and v k value. Payoff of kth highest bidder: v k x k – b k+1 x k = (v k - b k+1 ) x k

83 GSP equilibrium analysis Full information Nash equilibrium NE means no bidder wants to change positions Nash eqm is a bid profile b 1,…, b K such that (v k - b k+1 ) x k (v k - b m+1 ) x m for m>k (v k - b k+1 ) x k (v k - b m ) x m for m

84 Locally Envy-Free Definition: An equilibrium is locally envy-free if no player can improve his payoff by exchanging bids with the player ranked one position above him. Motivation: squeezing – if an equilibrium is not LEF, there might be an incentive to squeeze. Add the constraint for all k (v k - b k+1 ) x k (v k - b k ) x k-1

85 Stable Assignments Close connection between GSP equilibria / Competitive eqm / Stable assignments ! Think of bidders being matched to positions. Matching postion i to bidder k with price p k gives bidder payoff: (v i -p k )x k and position payoff p k x k Stability: no bidder/position want to block. All stable assignments are efficient (assortative). Relevant blocks are bidders looking to move up or down one position. (think about this).

86 Stable assignments At a stable assignment, matching is efficient. Each position k commands a price p k. Prices that support a stable allocation satisfy: (v k - p k ) x k (v k – p k-1 ) x k-1 (v k - p k ) x k (v k – p k+1 ) x k+1 These are the conditions for a competitive equilibria Essentially they say that bidder k demands position k So therefore at these prices, supply = demand!

87 Equivalence Result Theorem: Outcome of any locally envy-free equilibrium of the GSP is a stable assignment (i.e. competitive equilibrium allocation) Provided that |N|>|K|, any stable assignment (i.e. competitive equilibrium allocation) is an outcome of a locally envy-free equilibrium.

88 GSP equilibrium prices p2p2 p1p The set of competitive equilibrium prices corresponds to the set of GSP equilibrium prices! Vickrey prices GSP eqm

89 Revenue and Prices Theorem There exists a bidder-optimal competitive equilibrium (equivalently, GSP equilibrium) and a seller-optimal one. The bidder optimal competitive equilibrium is payoff-equivalent to the Vickrey outcome. Corollary: any locally envy free GSP equilibrium generates at least as much revenue as Vickrey.

90 Internet Advertising Markets

91 Todays Lecture Sponsored Search Market Recap of last time Examples of GSP/Comp Eqm/Vickrey Auction design & platform competition Display Advertising Market Structure and organization of the market Form of contracts, auctions vs prices Heterogeneity, targeting and conflation

92 Sponsored Search Recap Search engines sell positions on results page Advertisers bid for keywords on per-click basis Generalized second price auction for each query Simple model of auction setting shows that: Usually range of market clearing (per click) prices Vickrey auction leads to lowest mkt-clear. prices. Many possible GSP equilibrium outcomes, but the payments coincide with mkt-clearing prices. Equivalence btwn mkt-clear prices, GSP outcomes and stable matchings of advertisers to positions.

93 Example Two positions with 200, 100 clicks Three bidders with values $2, $1, $1 Efficient assignment is assortative Supporting (stable) prices Bidder 2 pays $100 for slot 2, (or p 2 = $1 /click). High enough to deter bidder 3 => at least $100, but not so much that bidder 2 wants to drop out. Bidder 1 pays $ for slot 1, p 1 [1,3/2]. High enough to deter bidder 2 => at least $200, but not so much that bidder 1 wants to drop down.

94 Example, continued Two positions with 200, 100 clicks Three bidders with values $2, $1, $1 GSP equilibrium Efficient matching, payments of $1, and $p 1. Bids required to support these payments Bidder 3 bids $1 per click Bidder 2 bids $p 1 [1,3/2]. Bidder 1 bids at least p 1 Easy to check that no bidder benefits from deviating… For each set of competitive prices, there is a set of GSP eqm bids, and vice-versa…. Revenue is $100 + $( ), or $300 to $400 total.

95 Compare to Vickrey auction Two positions with 200, 100 clicks Three bidders with values $2, $1, $1 Vickrey auction Efficient matching. Bidder 2 pays $100 (displacing 3) Bidder 1 pays $200 (displacing 2,3) VCG payments are $100, $200. Total $300. GSP prices are at least as high as Vickrey!

96 Another example Three positions with 300, 200, 100 clicks Four bidders with values $3, $2, $1, $1 Efficient assignment is assortative Supporting (stable) prices Bidder 3 pays $100 for slot 3, p 3 = 1. Bidder 2 pays $ for slot 2, p 2 [1,3/2]. Bidder 1 pays $ for slot 3, p 3 [4/3,2]. Relationship between VCG and GSP eqm VCG payments are $100, $200, $400, revenue $700. GSP payments range from $700 up to $1000.

97 Stable prices, generally Stable prices satisfy (v k - p k ) x k (v k – p k-1 ) x k-1 (v k - p k ) x k (v k – p k+1 ) x k+1 Re-arranging we get p k-1 x k-1 p k x k + v k (x k-1 -x k ) p k-1 x k-1 p k x k + v k-1 (x k-1 -x k ) This gives us a relationship between price of one slot and the price of the slot above… can solve for stable prices from the bottom up…

98 Features of Equilibrium Allocation is efficient (assortative) Increasing price of marginal clicks Varian points out this is testable. Implies bidders are click-constrained! Pricing should be linear if bidders satiated… Bids reveal bounds on bidder values. Apparently not so easy to invert in practice. Actual bidding is surprisingly unstable…

99 Ascending auction What if there is incomplete information about values – does this change things, or is there a naural process through which market equilibrates? Suppose price rises from zero, advertisers can drop out at any time, fixing their bid. Theorem (Edelman et al.). There is a unique perfect equilibrium in which advertisers drop out in order of their values. The equilibrium is efficient and the prices are Vickrey. The equilibrium is an ex post equilibrium – no one wants to go back and change their bidding after the auction ends.

100 Choices in Auction Design How many slots to sell? Would search engine want to restrict slots available? Could this ever increase revenue? Efficiency? Setting a reserve price? What is the optimal reserve price? Is it better to use a reserve price, or restrict slots? Clickability and squashing What if ads have different clickability Should you incorporate this in the auction? How?

101 Example: Slot Restriction Two positions with 200, 100 clicks Three bidders with values $2, $1, $1 Should the seller sell only one position? Focus on lowest equilibrium (Vickrey) prices. Selling two positions: revenue of $300. Selling one position: revenue of $200. Bidder 2 and 3 will pay up to $1 per click. Market clearing price is $1 per click for Bidder 1.

102 Example: Slot Restriction Two positions with 200, 100 clicks Three bidders with values $3, $3, $1 Should the seller sell only one position? Selling two positions: revenue of $500. Bidder 2 will pay $1 /click for slot 2 Bidder 1 will pay $2 /click for slot 1 Selling one position: revenue of $600. Bidder 2 will pay up to $3 per click for slot 1 Market clearing price is $3 per click for Bidder 1.

103 Example: Reserve Prices Two positions with 200, 100 clicks Three bidders with values $2, $1, $1 Can the seller benefit from a reserve price? No reserve price: revenue of $300. Reserve price of $2: revenue of $400 Sell only one position, but for $2 per click!

104 Example: Reserve Price Two positions with 200, 100 clicks Three bidders with values $3, $3, $1 Can the seller benefit from a reserve price? No reserve price: revenue of $500 (or $600 if sell just one position). Reserve price of $3 (and sell both positions): revenue of $900! In general, is it better to use a reserve price, or to adjust the number of slots for sale?

105 Bidder-Specific Click Rates Some ads may be more relevant than others. eg if query is Pottery Barn, what ad will get clicked? Extended model where click rates differ. Suppose Pr(click) = a i x k Values: u ik = v i (a i x k )= (v i a i )x k Bids are still made on a per-click basis Value rank: rank bids by expected revenue, by b i a i Eqm allocation will maximize total value. Bidder-optimal eqm will be payoff-equivalent to Vickrey Bid rank: rank bids directly by b i. May not be efficient, but may raise revenue.

106 Squashing Example Two positions with 200, 100 base clicks Three bidders per-click values $2, $1, $1 click-thru rates: 2,1,1 Rank bids by bid*CTR Bidder 2 pays $1 per-click for position 2 Bidder 1 pays $0.50 per-click for position 1 (why?) Total revenue: $1*100 + $0.50*400 = $300.

107 Squashing Example Two positions with 200, 100 base clicks Three bidders per-click values $2, $1, $1 click-thru rates: 2,1,1 Rank bids by bid (i.e. treat B1 as if CTR=1) Bidder 2 pays $1 per-click for position 2 Bidder 1 pays $1 per-click for position 1. (why?) Revenue: $1*100 + $1*400 = $500! Can squashing would lead to inefficient matching of bidders and positions? When?

108 Issues not modeled Is each query a separate competition? Advertisers really have portfolio of bids & broad match… They also have budget constraints, decreasing returns. They also have a choice between competing platforms. Model doesnt allow for much uncertainty Click rates, effectiveness of advertising are known. Seems to be a lot of experimentation in practice. Why? Many aspects of search not captured How do people decide whether/what to click? Is there an interaction with organic search? Broad match and the use of algorithms… very important.

109 Platform competition Current search market (approx.) Google: 70% market share, RPS maybe $0.08 Yahoo!: 20% market share, RPS maye $0.05 Microsoft: 10% market share, RPS maybe $0.04 Yahoo! and Msft strategic partnership Agreement from summer 2009, just approved. Searches on Y! will show Msft results and ads. Questions: What explains the difference between the platforms, particularly the difference in monetization? Are the platforms competing in a meaningful sense?

110 Platform competition, cont. Scale economies: more searches means… Cheaper for advertisers to bid on a per-search basis, if there are fixed costs to campaigns. Easier for advertisers to reach critical mass of consumers, if they want to raise awareness. More possibilities for platforms to experiment, estimate click rates and improve broad match algorithms. How could we try to distinguish these hypotheses? Is scale a barrier to entry or barrier to competition?

111 Platform competition Competition for users/searchers Try to make algorithmic results better Syndication deals to buy searches Competition for advertisers Is advertising on platform A a substitute for advertising on platform B? Not immediately clear. If advertisers have diminishing returns or budget constraints, yes – there is a market for clicks. How should will changes in the design of platform A to impact the competition on platform B? Example: Yahoo! implements are reserve price system. Competition between auction platforms is analagous to price competition but not as well understood.

112 Internet display advertising Real estate on non-search web pages Wide variety of ads: text, graphical, video, etc. Wide variety of advertisers: brand, performance, etc. Differences with search advertising Intent: search query makes it easier to discern users intent; Less clear if user is reading their or browsing the web. Search traffic is controlled by small set of firms that get to impose standards, specify form of contract and design markets. Display advertising opportunities are controlled by many, many publishers, so market is more fragmented. Result has been intermediaries (such as Google, but others as well) trying to create/design market for advertising to be traded.

113 Contract design Different types of contracts Pay-per-impression (CPM): advertisers pay to have ad shown to a fixed number of eyeballs. Pay-per-click (CPC): Advertisers pay for clicks. Pay-per-action (CPA): Advertisers pay for a conversion or sale, or for some action (e.g. filling out a form post-click). Contract design involves trade-offs in Incentives for publishers/advertisers Costs of certifying monitoring behavior and reporting Risk-sharing between advertisers and publishers. Different advertisers/publishers use different contracts. Performance advertisers (CPC), brand advertisers (CPM) Large publishers (CPM), small blogs and publishers (CPC).

114 Market design Different models for advertising markets/sales Large publishers typically have sales forces that negotiate sales of guaranteed impressions --- contracting can take place well in advance of delivery (e.g. buy now for August). Remnant inventory is often sold through ad networks and exchanges. These are often spot auction sales. Advertisers submit bids, and market makers use algorithms to predict clicks and determine allocation. Example: Google uses a version of its search auction to place search ads on non-query web pages (AdSense). Market design questions: When should the market clear: Advance or real time? How should the market clear: posted prices or auctions? Will there be a dominant platform for ad sales?

115 Targeting and Conflation Targeted advertising Traditional advertising involved limited targeting (e.g. everyone watching Law & Order) Internet advertising allows advertisers to target users based on demographics, geography, time, recent search behavior, etc. Many believe that internet advertising will become progressively more targeted, with better and better matching of ads to users. But, there are also costs to targeting!

116 Conflation Evolution toward targeting means that each ad becomes its own product. This is not, historically, how markets have evolved. Example: market for wheat (Debreu) Initially sold by sample each transaction different Standard contracts and grades of wheat allowed for thick markets, futures contracts, lower transaction costs. Conflation: treat things that arent exactly the same as the same in order to create better functioning markets.

117 Market Thickness Targeting can create thin markets Facebook example, prices in spring 2009 Show ad to 1,000 Harvard undergraduates: $0.50 Show ad to 1,000 Havard econ majors: $0.05 Whats going on? This is a very thin market for ads shown to Harvard econ majors, resulting in a low price! Targeting creates a large number of markets, some are likely to be thin markets and this makes it hard to get all the prices right. Conflation: treat econ majors as undergraduates, or at least apply undergraduate bids to econ major impressions.

118 Cherry-picking and safety Targeting can also make markets unsafe by allowing savvy advertisers to cherry-pick Example: Yahoo! Happy Contract McDonalds asks Yahoo! to show its ads only on sunny days and when the stock market is up. This leaves Burger King and Wendys with the inventory on rainy days when the market is down. Similar problems can arise in search auctions Bid for auto insurance, but only in Palo Alto. Solutions: eliminate targeting? ensure advertisers a representative set of impressions?

119 Conflation: search advertising Search advertising appears very targeted: can bid for any of millions of keywords. Yet there is also a lot of conflation One bid applies to all position on the page One bid (eg auto insurance) can be applied to many other keywords (eg auto insurance companies). One bid applies to many users, and maybe to AdSense. What is being conflated are clicks in different contexts. Conflation can mean same bid applies or is scaled mechanically according to an exchange ratge (e.g. a discount for AdSense clicks).

120 Targeting and Conflation When many heterogeneous goods are being sold, there are important set of trade-offs in defining the products for sale… Targeting, or finer product definition, means Improved (more efficient) matching, but Potential for thin markets Potential for cherry-picking Conflation is a key element of market design

121 Simultaneous Ascending Auctions (and Radio Spectrum Licenses)

122 Todays Lecture Background on radio spectrum auctions The simultaneous ascending auction Example, and magic of the market Theory of these auctions Evidence on how they work in practice What can go wrong, and why. Next time: complex auctions, bidder strategy and innovative spectrum auction designs.

123 FCC Spectrum Auctions Auctions to allocate radio spectrum Suggested by Coase (1960), and adopted by the FCC in 1994, followed by UK, Germany, Netherlands, Belgium, Mexico, India, etc. Large auctions in which telecommunications companies may pay billions of dollars for spectrum licences. Structure of typical auction Government (e.g. FCC) specifies a set of licenses to be sold. Each license conveys the right to use a portion of the spectrum in a certain geographic area. Licenses are sold in an auction, often using a simultaneous ascending auction designed by Milgrom-Wilson-McAfee.

124 Structure of the Problem Potentially many different goods for sale E.g. license for San Francisco very different than license for Death Valley. Potentially bidders with different objectives E.g. Verizon may want spectrum to add 3G; rural telco might want spectrum for another purpose. Substantial uncertainty about price/value Illiquid secondary market, not many licenses or auctions, uncertainty about technology evolution.

125 Example Two licenses: New York and San Francisco Three bidders: A, B, C. NYSF A4035 B6050 C8060 Lets run an SMR auction… Efficient allocation: C wins #1, B wins #2.

126 SMR/SAA Rules Simple case: each bidder allowed at most one license. Auction Rules Seller sets initial price, and is the high bidder on each license. First round: each bidder can submit a bid for one of the licenses. If a license gets multiple bids, a coin flip determines the new high bidder. If it gets no bids, the previous high bidder remains. In subsequent rounds, bidders who are standing high bidders dont bid, other bidders must submit a bit or else exit the auction. Each new bid must be some increment (say 5% or 10%) above the standing high bid on a license. The auction ends when there are no new bids. Each standing high bidder pays its current bid and receives its license.

127 SMR/SAA Rules General case: bidders can bid for many licenses. Auction Rules Seller sets initial price, and is the high bidder on each license. Bidders can submit bids on any set of licenses including raising their own high bids, but must respect an activity rule. Bids must be at least an increment above the current price. If a license gets one new bid, that bidder becomes the new high bidder. If no new bids, standing high bidder remains. If multiple new bids, a coin flip determines the new high bidder. After each round of bidding, information about bids revealed. Auction ends when there are no new bids. Each standing high bidder receives its license at its last bid price.

128 Why a simultaneous auction? Relative to sequential auctions Bidders have more chance to coordinate their bids on different licenses – may be important if bidders want to assemble packages. Information is aggregated all at once – may be important if lots of uncertainty about value. Should leads to greater degree of arbitrage and similar prices for similar items.

129 Why a multiple round auction? Relative to sealed bidding, information revelation… Allows bidders to identify target licenses on the fly Mitigates inefficiency due to the winners curse Helps bidders to assess roaming opportunities. The SAA design has some other virtues.. Its transparent, and easy to check up on the govt. Activity rule prevents super-slow bidding. Skeptics might argue… Design is vulnerable to demand reduction/collusion. Design does not facilitate new entry or package bidders.

130 Why an SMR auction? Suppose we make the following assumptions: Each bidder places a dollar value on each of the licenses, and wants to maximize its profit – equal to difference between value and price paid. The governments objective is efficiency, defined as allocating the licenses to maximize the sum of the dollar values of the winners. The government does not know the license values of the bidders. (What if they did?). Were ignoring many potential complications, to which well return.

131 The magic of the market Bidding is straightforward if in each round bidders submit bids on the license that offers them the most profit at current prices. Theorem. If bidders want one license (or multiple licenses but substitutes values) and bid straightforwardly, the SMR auction leads to an efficient allocation and competitive eqm prices. Magic of the market Auction outcome is as if the seller knew all the values and used a computer to find the efficient allocation & mkt-clearing prices. Biders have no regret – at the final prices, each winner gets exactly the license that gives it the most profit, and no loser would like to be a winner. Put another way, the auction is a price discovery mechanism to find the efficient (market clearing) prices!

132 Example Three bidders A, B, C. Two licenses: NY and SF. NYSF A4035 B6050 C8060 Efficient allocation: C wins NY, B wins SF. Lets see how the SMR auction works (in theory)…

133 SMR Auction Suppose prices start at $0, and the minimum raise is $1. Initially everyone bids on NY. When prices reach $5, $0: A bids on SF; B and C continue on NY. When prices reach $11,$1, bidder B starts switching back and forth between NY and SF. (arbitrage) When prices reach $45, $35, bidder A drops out, so B wins SF at $35 and C wins NY at $45. NYSF A4035 B6050 C8060 License Values

134 Alternative: Vickrey auction Sellers asks bidders to write down their values and mail them in. Seller allocates licenses to maximize total value. Prices are set so that (two equivalent ways) Each bidder makes a profit equal to total value with them in the auction minus the total value without them in the auction. Each bidder pays the value he displaces by entering the auction and receiving his allocation.

135 Vickrey auction Efficient allocation gives $130 C gets 1, worth $80 B gets 2: worth $50 Without C, value would be $95 B would get 1, worth $60 A would get 2, worth $35 So C adds $130 - $90 = $35 in value. C values 1 at $80, so must pay $45. Without B, value would be $115 C gets 1, A gets 2, so $80 + $35. So B adds $130 - $115 = $15. B values 2 at $50, so must pay $35. Vickrey prices: $45, $35 - as in SMR! #1#2 A4035 B6050 C8060 License Values

136 Vickrey auction Under the Vickrey rules, bidders do best to reveal their true values: its strategy-proof! If you bid more or less than your value, you dont change what you pay unless you change what you win. If you bid more or less and it changes what you win, you make less profit. Logic is similar to the other Vickrey cases we considered (T-bills & sponsored search).

137 Vickrey strategy Suppose B bids $60 and $0. Then B wins 1, C wins 2. Total value is $120 Bs value for 1 is $60 Cs value for 2 is $60 Without B, value would be $115 C gets 1, A gets 2, so $80 + $35. So B adds $130 - $115 = $15. So B must pay $55 for #1 and makes a profit of only $5, less than the $15 it gets from truthful reporting. #1#2 A4035 B6050 C8060 License Values

138 SMR auctions in practice SMR auctions (and clock auction variants) are very common for spectrum and other goods. What is the evidence on their performance? Well start with a very successful UK auction, Then well look at some European auctions that werent so successful and think about what can go wrong. Next time, we ll discuss some of the US auctions, which are often more complicated, and sometimes surprising. Finally, well talk about some innovative new auction designs that are starting to be used, and their properties.

139 UK Auction of 3G Spectrum In 1998, British Radiocommunications Authority (RA) was designated to sell spectrum licenses for third generation (3G) wireless services. The RA decided to follow the FCC and use an auction: banks estimated an auction might raise £500 million ($750 million). The RA employed a small group of auction designers. Paul Klemperer (former Stanford GSB student, and my advisor at Oxford) was principal auction theorist. Economists Jeremy Bulow of Stanford GSB and Ken Binmore of LSE were also involved.

140 Deciding what to Sell An important question is what to sell How many licenses? Exactly what spectrum? In this case, european countries had agreed to all designate certain spectrum for 3G use; the main question was whether to sell 4 or 5 licenses. Licenses grant owner the right to use the spectrum, and an obligation to build out a network of cell towers to provide coverage. More service is desirable, but concern as to whether it was reasonable to expect buildout of five separate networks.

141 Identifying Bidders There were four incumbent phone companies in the UK, operating 2G services. Vodafone, Orange, British Telecom, One-to-One. Complication: Vodafone was trying to take over Mannesman, which owned Orange. Vodafone had agreed to divest Orange, but post-auction. Govt decided to let both Vodafone and Orange bid. Now, the big problem: what auction design to use, and would the design attract several other bidders?

142 Ensuring competition SMR auction is efficient and prices are competitive given the set of bidders who participate assuming bidding is straightforward In the UK, entry was the serious concern With four licenses, and four strong incumbents, new bidders might not bother to show up. Without a new bidder, prices might be very low. The bidding team considered an Anglo-Dutch design – SMR until five remaining bidders, then a final sealed bid round … could this have helped?

143 What happened The RA finally decided to sell five licenses. License A reserved for a new entrant Licenses A, B a bit bigger than C,D,E. Bidders can only bid on one license at a time In first round, everyone bids whatever they want on one of the five licenses – then single increment bids. There were thirteen entrants in total Incumbents plus nine entrants including major players like Telefonica, Hutchinson Whampoa, etc.

144 What happened

145 Auction ends after 150 rounds….

146 Success in the UK Four incumbents and one entrant won licenses. Auction netted £22 billion, about $39 billion dollars – the biggest auction ever. Some other auctions held around the same time, however, were not as successful….

147 Entry problems Netherlands auction of 3G spectrum in Following UK lead, decided to sell five licenses using an SMR auction. However, there were some differences The Netherlands has five incumbent (2G) operators. There was no prohibition on bidding partnerships. What happened?

148 Netherlands auction Prior to auction, major outside telecom firms (Deutsche Telekom, DoKoMo, Hutchinson Whampoa) all reach partnership agreements with an incumbent. This left just one entrant, a startup called Versatel. What happened in the auction On day 1, Telfort (owned by BT) sends Versatel a letter saying that it cant win and should drop out immediately! Versatel shortly drops out: total revenue of 3bn euros – at UK prices, auction would have raised 10bn euros.

149 Bidding problems German GSM auction in Ten nationwide licenses. Bidders allowed to win multiple licenses. First bid at 10m DM, then 10% price increments. Bidders: two very strong bidders, Mannesman and T-Mobile, and some small guys. What might you be worried about here?

150 German GSM Auction What happened in the auction Round 1: Mannesman bids 36.6m for each of 5 bands, and reduces eligibility. Round 2: T-Mobile (Deutsche Telekom) bids 40m for the other five bands, reduces eligibilty. No bids in round 3!

151 Complications Even in the UK setting where things look nice, one might be worried about a number of issues Consumers might care who are the winners: maybe total value isnt the right objective. Firms may care who are the other winners, or may be just learning their values in the auction. The SMR is designed for efficiency, but maybe isnt the design that maximizes revenue. Maybe competitive prices are too high – because they leave firms without enough money to build their networks. The SMR design didnt deal with the problem of how many licenses – the Germans tried to, but with limited success!

152 Conclusion Magic of markets: auctions can be a powerful tool for price discovery and efficient allocation. But plenty of things can go wrong. Successful auctions need to: Induce bidders to participate Induce bidders to bid competitively Considerations around the auction must be accounted for (what to sell, what are the objectives, etc.): The auction is always bigger than you think!

153 Spectrum Auctions: Strategy and Design

154 Todays Lecture Simultaneous Ascending Auctions Bidder strategy in complex auctions The exposure problem Budget constraints and forecasting The AWS auction New auction designs

155 Refresher: SAA Rules Auction consists of multiple rounds. Round begins with standing high bid on each license (initially the seller), and a minimum bid increment. Each bidder can submit bids on any number of items, subject to an eligibility and activity rule. If no bids on a license, standing high bidder remains. If multiple bids, one bid selected at random to be high bid. Information about bids is revealed to bidders. Auction ends when no new bids are submitted.

156 Theory of SMR auctions Suppose bidders view licenses as substitutes and bid straightforwardly, i.e. each round bid for most desired licenses at current prices. Then, Arbitrage: the final prices for identical items will differ by at most one bid increment. Competitive equilibrium: the final prices will approximately competitive equilibrium prices. Efficiency: If the bid increments are small, the final license allocation will be efficient. Results due to Gul and Stacchetti (2000), Milgrom (2000).

157 SAA auctions in practice SAA auctions (and clock auction variants) are very common for spectrum and other goods. What is the evidence on their performance? In the UK spectrum auction, the SMR auction appeared to work very well – simple setting, not much strategy. In some other European auctions, we observed problems. Now well look at some evidence from US auctions, where things are often more complicated, and surprising. Focus on elements that create role for strategy Exposure problem, activity rules, budgets & complexity.

158 The exposure problem New entry may require a package of licenses Danger for entrant: might end up with very expensive spectrum but not enough for viable entry. Why not re-sell? Problems include opponent budgets, other package bidders, bargaining and agency problems. Fear of being exposed to losses can lead to conservatism, and auction outcome may not be efficient. Exposure problem is caused by uncertainty. Bidders may have to make committing bids early in the auction, when they are uncertain about how much it will cost to complete their target package.

159 Exposure problem Two licenses A and B Entrant has value 100 for the pair, else zero. Individual bidders for A, B with values U[0,125]. Suppose A is sold first, followed by B. Solve for entrants optimal strategy In entrant loses A, wont bid for B and gets profit = 0. If entrant wins A, will bid to 100 for B (why?) and expects a profit (4/5)* [100 – 50] – p A = 40 - p A Therefore in the first auction, entrant will bid up to 40.

160 Efficiency vs equilibrium pA pB Entrant wins both licenses Entrant wins A only PROFIT LOSS 125 Efficient for Entrant to win if individual bidder values are inside pink line, ie if 100 > pA + pB. 100

161 Strategy for exposure problem Strategy can potentially resolve uncertainty. Example Entrant has value 100 for the pair A & B. Individual bidder for A has value U[0,100] Individual bidder for B has value U[0,60] Possible ways the auction could go A sells first, B sells first, or prices rise together? Entrant may be able to have some control over this.

162 Auction timing Suppose license B sells first If entrant wins B, expects to pay 50 for A. Value of winning B: 100 – 50 – price of B Optimal strategy: stop bidding at p B =50. Expected profit Suppose license A sells first If entrant wins A expects to pay 30 for B. Value of winning A: 100 – 30 – price of A. Optimal to stop on A at p A =70, exp. profit 24.5.

163 Controlling the Pace Best case for the entrant Prices rise on both licenses, but faster on A. If and when prices reach p A =60, p B =20, entrant exits. At p A =60, p B =20, value of winning A (or B) is zero. Expected profit is Idea: entrant should raise prices in a way that provides the most information before becoming committed to a purchase.

164 Strategic individual bidder Entrant with value 20 for licenses A & B together. Two individual bidders License A bidder with value 10 License B bidder with value c B ~ U[0,30] License B bidder prefers to see price on A rise first. Entrant will exit when p A = 5, so possible to buy B for zero. License B bidder can use strategy to exacerbate the exposure problem for the entrant!

165 Activity Rules Activity rules necessary to keep auction moving Each license assigned some number of points Bidder start with eligibility points, must use them each round or else have their eligibility reduced. Problem for a package bidder – creates exposure risk. Activity rules also complicate arbitrage Suppose NY worth 200, LA worth 100, SF worth 100. If youre high on NY and get bid off, can switch to SF/LA, but what if youre high on SF/LA and are bid off LA only? Serious issue if some licenses much bigger than others!

166 Activity rules and timing Strategy to deal with activity rules Bidders can park points to save them for later. Bid on large licenses to maintain flexibility Auction timing: this suggests that… Bidding will tend to start on large licenses; Large license licenses will tend to clear first. Similar licenses may not sell for the same price.

167 Bidding activity (FCC auction 35) Fraction of bids on large licenses Fraction of bids on small licenses

168 Timing of final bids (auction 35) Round of final bid plotted against license size in bid units Large licenses clear first Variation in clearing round

169 The AWS Auction Use FCCs auction of Advanced wireless service in 2006 to illustrate bid strategy and features of large auctions. This was a large, complicated auction with a very surprising outcome that has subsequently influenced auction design.

170 US sale of AWS spectrum (2006) Background for the auction 90 MHz of nationwide spectrum, 1122 licenses Regional licenses (10,10,20 MHz), 6 to cover US Smaller licenses (10,20,20 MHz), 176 to cover Total of 168 bidders, including major incumbents, smaller firms. Two potential national entrants: SpectrumCo and WirelessDBS. Entrants face a difficult problem Theory doesnt provide much guidance on how to bid in a way that avoids the exposure problem…

171 SpectrumCo problem Goals for the auction Acquire 20 MHz of spectrum covering 85% of US population, without spending more than budget. If this is impossible, dont buy anything? Strategic thinking Beware the exposure problem! Try to figure out how much it will cost to buy target amount of spectrum… but how?

172 Hard to forecast prices!

173 Role of bidder budgets Many bidders appear to be limited by budgets, rather than values --- a neglected but important pattern. With many substitutable items for sale, a straightforward bidder will eventually bid its budget and continue doing so each round. Even if some bidders dont behave this way, aggregate demand elasticity will be anchored around -1 as prices rise. Empirical proposition: Auction exposure, defined as sum of all bids in a round should rise faster than auction revenue and level off at final revenue.

174 Exposure forecasts prices Sum of high bids (revenue) Sum of all bids (exposure) FCC Auction 35

175 Forecasting in the AWS auction Sum of high bids (revenue) Sum of all bids (exposure) FCC AWS Auction

176 Not everyone is a budget bidder T-Mobile Dolans Exposure of individual bidders in the AWS auction Spectrumco

177 Applying the budget hypothesis Why is an accurate forecast of final prices useful? Avoid exposure problem: allows an entrant to identify if a desired aggregation is achievable at reasonable price. Acquire licenses cheaply: allows a bidder to anticipate price anomalies if licenses clear in sequence. Would budget forecasting have worked in past auctions? Requires exposure to peak sufficiently early. Requires exposure not to overshoot final revenue.

178 Exposure peaks early in auction

179 Peak/final exposure FCC sales Overshooting in small auctions No overshoot in large auctions

180 How the AWS auction worked Recall basic structure of licenses: Large regional licenses (three bands, 40 MHz) Small EA/CMA licenses (three bands, 50 MHz) Competitive landscape: 168 bidders, major incumbents, and two potential national entrants SpectrumCo: cable TV consortium Wireless DBS: satellite TV consortium

181 Controlling the pace Bidding started on large regional licenses. But due to uniform starting point, prices rose uniformly on coasts/interior, creating serious exposure problem… In round 9, Spectrumco makes maximum possible jump bid on all Northeast and West regional licenses, doubling their prices from $750m to $1.5 billion. Shake-out: Wireless DBS takes waivers, then exits. FCC eliminates jump bidding in subsequent auctions. But prices continue to rise on the REAG licenses…

182 Rising prices in AWS auction

183 Budget forecasting At round 13, the situation is High bids on REAGs (40 MHz): $5.0 bn High bids on EA/CMAs (50 MHz): $0.7 bn Auction exposure had peaked at $14.2 bn. Cable consortium gives up REAG licenses and switches to smaller licenses, other major bidders do not. Why did no other large bidder switch? Large licenses easiest way to buy large quantity and no reason a priori to expect theyd be much more expensive. Incumbents did not face exposure problem: less need to forecast prices and discover budget theory.

184 Rising prices in AWS auction Spectrumco band switch

185 Rising prices in AWS auction

186 Timing of final bids in AWS Large REAG licenses

187 Another exposure problem At round 19, the situation is High bids on REAG licenses: $7.6 bn High bids on EA/CMA licenses: $2.3 bn Budget algebra Implied maximum budget for small licenses: $6.6 bn. Estimated price of 20 MHz national: $2.6 bn.

188 Rising prices in AWS auction

189 Price per MHz-pop of REAG licenses Price per MHz-pop of EA/CMA licenses

190 Rising prices in AWS auction Price per MHz-pop of REAG licenses Price per MHz-pop of EA/CMA licenses

191 Rising prices in AWS auction Price per MHz-pop of REAG licenses Price per MHz-pop of EA/CMA licenses

192 Similar spectrum, different prices US auction of AWS spectrum (2006) BandMHz License type Price ($/MHz-pop) Price (US 10Mhz) A20CMA$0.40$1.1 bn B20EA$0.43$1.2 bn C10EA$0.52$1.5 bn D10REAG$0.62$1.8 bn E10REAG$0.61$1.7 bn F20REAG$0.73$2.1 bn

193 SpectrumCos Licenses (20 MHz)

194 Failure of price arbitrage Table 1: Prices Paid by the Five Largest Buyers in the AWS Auction BidderTotal Amount PaidMHz-PopsPrice per MHz-Pop SpectrumCo$ 2,377,609,0005,267,189,470$ 0.45 Cingular1,334,610,0002,436,458, T-Mobile4,182,312,0006,638,718, Verizon2,808,599,0003,840,952, MetroPCS1,391,410,0003,840,952, Four incumbents$ 9,716,931,00014,361,573,190$ 0.68

195 New auction designs AWS auction spurred new designs 700 MHz auction in United States British WiMax auction These auctions allow for package bidding British design also involves new twists Vickrey or near-Vickrey payment rule Conflation in license definitions

196 US 700 MHz Auction Three main bands A and B bands were 10MHz C band was 20 MHz, with special rules Bidders allowed to submit a package bid for the entire national C band. Lobbied for by Google, although they didnt buy. Package bidding favors entrants – can create a threshold problem for smaller bidders! In the auction, C band went at a huge discount.

197 British wimax auction Very innovative new design to sell spectrum in the UK. 120 MHz of spectrum divided into 42 5-MHz blocks. First stage clock auction Seller calls out prices Bidders call out number of blocks they want Stage ends when Demand <= Supply. Sealed bids: if overshoot in first stage, bidders can add bids. Then, seller takes all bids and computes efficient allocation. Bidders pay Vickrey prices, … but if Vickrey prices are too low (outside the core), prices are increased until the resulting allocation is in the core!

198 British WiMax, cont. Auction also includes third stage Winners are guaranteed set amount of spectrum Third stage determines who gets which blocks. Sealed bid package Vickrey auction (with prices adjusted up if result is outside the core). Conflation in auction design Different items are treated as identical (conflated) Additional round used to de-conflate the items. Conflation is very common in setting up markets.

199 Conclusions Simultaneous multi-round auctions are commonly used for selling radio spectrum, and many other goods. Design has many advantages in terms of revealing information, giving bidders flexibility, but auctions can also be complex creating a role for strategy. Innovative new designs such a British auction are trying to simplify the bidder problem… Experience of Spectrumco shows how economic theory can be practical as well as fun!

200 Package Auctions

201 London Bus Routes City of London auctions off service contracts for bus routes in Greater London. How it works City decides bus network, frequency of buses, types of buses, exact routing etc. – provision is outsourced. City uses sealed bid auctions allowing bids for packages of routes as well as individual routes. Bids state a fee to be paid to the city to operate the buses for five years – collected fares go to the city.

202 Why package bids? Operator cost structure To operate routes, must have storage and maintenance facility – fixed cost, can accommodate several buses. So costs per route may decline if operator has several routes – at least until capacity is reached. Bidding advantage in the auction Consider operator with zero cost on routes A,B. Suppose opponent bids on A,B are U[0,10] Bidding 5 for A, 5 for B => expected profit 2*5*(1/2)=5 Bidding 7.5 for A/B package => exp. profit 7.5*(3/4)=5.6!

203 London auction data Source: Cantillon and Pesendorfer, Auctioning London Bus Routes, 2006

204 Package bid discounts Note: marginal discount assigns full discount to smallest route in the package.

205 Interpreting the data Cantillon-Pesendorfer try to infer if package bidding reflects cost synergies or is used strategically. They estimate operator costs in the London market using the bid data… Findings: Mininmal or no cost synergies! Strategically use of package bids: bids are marked up over cost by 16.4% for individual routes, but only 11.4% for packages!

206 Package auctions Package bidding allows bidders to express complex demands in multi-good settings. A set of bus routes in London A set of spectrum licenses. A set of airport take-off and landing slots A complete search/display advertising campaign Today: discuss underlying theory, different auction methods, and some evidence.

207 The problems begin… Two items for sale, A and B Two bidders with values: ABAB No item prices clear the market. Such prices must result in bidder 1 efficiently buying both: p A 10, p B 10, and p A +p B 12!

208 SMR auction Suppose everyone know values (complete information) Bidder 1 should not bid! Bidder 2 will win one item at a very low price. With uncertainty about opponent values Bidder 1 may start bidding but will have to pay 10 for each to win both. More likely outcome – bidders split items, perhaps at low prices. The outcome is likely to be inefficient and maybe yield low revenue. Although recall Spectrumco overcoming exposure problem. ABAB

209 Package bids in the SMR Allow bidders to make package bids - e.g. $X for the package of items A and B. SMR with package bidding Each round, there is a provisional winner for each license – some provisional winning bids could be package bids. Bidders can submit new bids, individual or package, for any licenses they like. Seller takes new bids and existing bids (maybe including losing bids) and identifies highest revenue allocation. Auction ends when no new bids are submitted.

210 Auction of 700 MHz spectrum US auction of 700 MHz spectrum in B block: 10 MHz divided into 176 EA licenses C block: 20 MHz divided into 6 REAG licenses Bidders can make a national bid on the C block. What happened? Little bidding on C block – Google bid the reserve price, and Verizon bid a bit higher. Lots of bidding on the B block – prices about 4x that of the C block. But many other special features of the auction make it hard to identify the exact effect of package bidding.

211 Threshold problem SMR with package bidding Suppose bidder 1 starts by bidding 10 for AB. Bidders 2 and 3 have to make bids that sum to 11. Incentive to wait for other bidder to increase its bid. But then auction could end with inefficient package winner! ABAB

212 Who gets the advantage? It is hard to balance the playing field when some bidders have package preferences Individual bidding: creates difficult exposure problem for complements bidder. Package bidding: creates difficult threshold problem for individual bidders. Why package bidding changes things Effectively gives package bidder a chance to move second – e.g. bid 10, and let the auctioneer divide up the bid once the other bids are in!

213 Vickrey auction Vickrey auction with package bidding Bidders submit their values for all possible packages (could be a lot -- 2 N ) Seller finds highest value allocation, sets prices so that each bidder makes as profit the difference between value with them and without them. Desirable properties The outcome is efficient if bidders are truthful. Truthtelling is a dominant strategy

214 Vickrey auction: problems Consider our threshold problem example ABAB Bidders 2 and 3 win items. Each pays a Vickrey price of 2 => revenue 4. BUT, package bidder would pay 10!

215 Vickrey auction: problems Now suppose bidder 2,3 have lower values ABAB With honest bidding, package bidder wins. If bidders 2,3 report 10, each wins and pays 2 Small amount of collusion has a big effect!

216 Vickrey auction: problems Bidders may also want to split their bidding ABAB Honest bidding means 1 wins and pays 11. Bidder 2 can enter as 2A, 2B, each bidding 10 for a single item – wins both and pays 4! If bidders 2A, 2B bid 11 each, they each win and pay 2, so higher bids can mean lower revenue!

217 Budget constraints We saw that budget constraints seem to be important in spectrum auctions. They pose a big problem for Vickrey auctions Suppose items A, B are for sale. Bidder values A at 200, B at 100, budget of 150. Cant bid true values and be sure to stay under budget. Straightforward bid of 150 for A, 100 for B and 150 for the pair implies zero value for B if awarded A. Bidding with a budget & vickrey rules is complicated!

218 Core outcomes In markets with complements, market clearing prices may not exist. Core allocations are a useful generalization. An allocation is in the core if there is no set or coalition of players that could make a deal on their own from which all of them would benefit. All gains from trade are exploited The bad Vickrey examples are cases where the Vickrey outcome is not in the core.

219 Vickrey and Core outcomes Same example as before ABAB Bidders 2 and 3 win items, pay 2 each. But package bidder would pay 10! That is: the auction outcome is not in the core!

220 Core outcomes and auctions There is always at least one core allocation Example: assign items efficiently, have buyers pay their full value to the seller. Problem: unclear how to get bidders to reveal values! Day and Milgrom (2008) propose to use core-selecting auctions in which: Bidders are asked to submit bids Bids are treated as values. Seller finds core allocation that is bidder optimal.

221 Auctions vs exchanges With one seller, there is a core allocation. Bidder 1 wins the object, pays between 10 and 12. But if goods A and B belong to different sellers, the core is empty, because… Bidder 2 must get 0 Coalition of either seller and bidder 2 must get 10 So, each seller must get 10, but only 12 is available. ABAB

222 Pay as bid auctions London bus routes are a pay-as-bid auction Bidders submit bids Bids treated as values to find efficient allocation Bidders are asked to pay bids (seller optimal). Bernheim and Whinston (1986, QJE): the full information Nash equilibria of the pay-as-bid package auction correspond to the set of bidder-optimal core allocations.

223 Pay as Bid Auction ABAB Bidder 1 bids 10 for package A/B Bidder 2 bids b A and b B that sum to 10. Allocation is efficient, revenue is 10.

224 Pay as bid Auction Bidder 1 bids 12 for the package Bidders 2, 3 submit bids that Are each less than 10, and sum to 12. Allocation is efficient, revenue is 12. ABAB

225 Experimental evidence Does package bidding really help? Published reports of experiment suggest remarkable efficiency properties. Porter et al (2003, PNAS): efficiency of 100% in 23 of 25 trials, 99% in the other two! Hard to interpret these results As number of items grows, the number of possible values to use in the experiment grows as 2 n - huge!! Are these experiments focused on easy cases?

226 Easy and hard settings Straightforward bidding in SMR auction: in each round, bid for most desirable set of items at current prices. Kagel-Lien-Milgrom (2009) Setting is easy if straightforward bidding in SMR with package bidding leads to efficient outcomes, otherwise is hard. Use computer simulations to classify different settings as easy or hard, then run human experiments to see if difficulty of the setting matters.

227 KLM experiment design

228 KLM Results

229 KLM results, cont.

230 Summary of theory If the bidders view goods as substitutes, then Competitive equilibrium (CE) prices exist. There is a CE with minimal prices. This CE coincides with Vickrey auction outcome. This CE is a core allocation. In the general package preference case CE prices may not exist Vickrey auction may not yield core allocation. Non-Vickrey designs do not encourage truthful bidding Auctions suffer from exposure/threshold problems.

231 British wimax auction Very innovative new design to sell spectrum in the UK. 120 MHz of spectrum divided into 42 5-MHz blocks. First stage clock auction Seller calls out prices Bidders call out number of blocks they want Stage ends when Demand <= Supply. Sealed bids: if overshoot in first stage, bidders can add bids. Then, seller takes all bids and computes efficient allocation. Bidders pay Vickrey prices, … but if Vickrey prices are too low (outside the core), prices are increased until the resulting allocation is in the core!

232 British WiMax, cont. Auction also includes third stage Winners are guaranteed set amount of spectrum Third stage determines who gets which blocks. Sealed bid package Vickrey auction (with prices adjusted up if result is outside the core). Conflation in auction design Different items are treated as identical (conflated) Additional round used to de-conflate the items. Conflation is very common in setting up markets.

233 Conclusion Package auctions are finding increasing use for hard resource allocation problems. Vickrey auctions problematic because of low revenue, non-core outcomes. Alternative designs (pay-as-bid, Vickrey, SMR, etc.) trade off incentive and distributional properties. Package exchanges are fundamentally hard due to empty cores, but some interesting new ideas are being studied here as well.


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