1. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Chapter 18: Auctions 1

2. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Summary of main points In oral or English auctions, the highest bidder wins by outbidding the second- highest bidder. This means that the second-highest bidders’ value determines the price. A Vickrey or second-price auction is a sealed-bid auction in which the high bidder wins but pays only the second-highest bid. These auctions are equivalent to oral auctions and are well suited for use on the Internet. In a sealed-bid first-price auction, the high bidder wins and pays his value. Bidders must balance the benefits of bidding higher (a higher probability of winning) against the costs of bidding higher (reduced margin if they do win). Optimal bids are less than bidders’ private values.

3. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Summary of main points (cont.) Bidders can increase their profit by agreeing not to bid against one another. Such collusion or bid rigging is more likely to occur in open auctions and in small, frequent auctions. If collusion is suspected, do not hold open auctions; do not hold small and frequent auctions; do not disclose information to bidders—do not announce who the winners are, who else may be bidding, or what the winning bids were. In a common-value auction, bidders bid below their estimates to avoid the winner’s curse. Oral auctions return higher prices in common-value auctions because they release more information than sealed-bid auctions.

4. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Introductory anecdote: Bell Telephone In 1885, Bell Telephone Company of Canada established Northern Electric to manufacture its telephone equipment. By 2000, the company (now Nortel) had a market share of over $200 Billion Decade of bad investments, declared bankruptcy in 2011 Nortel approved for sale by bankruptcy court The court was unsure of the value of some of the company’s assets, such as the 6000 patents, and decided to sell these assets with an auction. The bidding started at $900 million but was pushed up to $4.5 billion after successive rounds of bidding.

5. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Introduction: Auctions Auctions are simply another form of competition, like price competition or bargaining. CarBargains is one company that uses auctions to help car buyers. In these auctions, though, sellers not buyers are competing. Local car dealers offer prices to a single consumer in a sealed-bid auction. Auctions set a price and identify the high-value buyer or low-cost seller. Auctions are often used in combination with bargaining, e.g., first an auction is used to identify the high-value buyers and then there is a negotiation over the final price.

6. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Oral Auctions Definition: In an oral or English auction, bidders submit increasing bids until only one bidder remains. The item is awarded to this last remaining bidder. Example: Suppose there are five bidders with values equal to {$5, $4, $3, $2, $1}. The $5 bidder will win the auction, and bids only slightly over $4 to do so. The “price” or winning bid is $4, or slightly above. The winning bidder is willing to pay $5 but doesn’t have to, so the losing bidders determine the price in oral auctions. Auctions identify the high-value bidder (“efficiency”) and set a price for an item, with no negotiating necessary. For these reasons, economists love auctions.

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

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

9. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Second-Price Auctions Definition: A Vickrey or second-price auction is a sealed-bid auction in which the item is awarded to the highest bidder, but the winner pays only the second-highest bid. This at first seems counterintuitive – why leave money on the table? But second-price auctions encourage bidders to bid more aggressively. William Vickrey and James A. Mirrlees shared the 1996 Nobel Prize in Economics for their work inventing the Vickrey auction and establishing that there is no difference in outcome between an oral and second- price auction.

10. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Second-price auctions (cont.) Because the winning bidder pays the price of the second- highest bid, bidders are willing to bid up to their values, so the outcome is the same as an oral auction. Second-price auctions are easier to run than oral auctions because the bidders can bid in remotely, and asychronously (at different places and times). Discussion: Why are eBay auctions equivalent to second- price auctions? Discussion: Why does eBay use second-price auctions?

11. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Sealed-Bid Auctions Definition: In a sealed-bid first-price auction, the highest bidder gets the item at a price equal to the highest bid. These auctions present a difficult trade-off for bidders: A higher bid reduces the profit if you win, but Also raises probability of winning Bidders balance these two effects by bidding below their values (“shading”). Experience and knowing the competing bidders are the keys to these auctions, but in general, bid more aggressively – shade less – if the competition is strong.

12. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Bid Rigging or Collusion Example: an oral auction with bidder values of {$5, $4, $3, $2, $1}. Suppose that in this auction the two high-value bidders have formed a bidding ring (also known as a cartel). The two decide NOT to bid against each other, so the cartel wins the item by outbidding the non-cartel members, i.e., price= $3. The cartel makes a profit of $1 which typically is split evenly between members. Bid-rigging is a criminal violation of antitrust laws in the US and many other countries. In one type of bid-rigging, cartel members re- auction the items won in a second-auction to cartel members in a second or “knockout” auction.

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

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

15. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Reacting to bid-rigging The government is frequently the victim of bid- rigging schemes. Learning from the government’s experience, some tips to avoid collusion: Do not rely on purchasing agents (those running the auction) who have little interest in buying at a low price. Instead, reward agents for making good (high- quality and low-price) purchases. Do not entangle purchasing agents with masses of red tape. Instead, permit them to negotiate (e.g., to bargain with the bidders) if they suspect bid rigging. But beware of patronage Do not use the procurement process to further a social agenda (small business set-asides, public lands, national defense, etc.) that is irrelevant to the goal of purchasing goods at low prices.

16. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Avoiding collusion (cont.) Keep cartels in the dark, so it is difficult for them to organize and to punish cheaters. do not hold open auctions; do not hold small and frequent auctions; do not disclose information to bidders—do not announce who the other bidders are, who the winners are, or what the winning bids are.

17. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Common-Value Auctions Definition: In a common-value auction, the value is the same for each bidder, but no one knows what it is. Each bidder has only an estimate of the value. Be careful in these auctions lest you suffer the “winner’s curse” If you win, you learn that you were the one who had the highest and most optimistic estimate of the unknown value of the item Bidders should reduce their value estimates to protect against this. If you are the auctioneer, release info to mitigate winners’ curse. Winner’s curse is worse when More bidders Other bidders have better information

18. Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Common-Value Auctions (cont.) To avoid the winner’s curse bid less aggressively as the number of bidders increases. In common-value settings, oral auctions return higher prices than sealed-bid auctions because oral bids reveal information. But oral auctions are more vulnerable to collusion. Discussion: Why do bidders wait until the last minute of the auction to submit bids on eBay?