All about auctions

Corporate finance, Personal finance

Most people’s understanding of auctions comes from personal experience, such as buying on eBay, at a live auction, or perhaps from seeing some of those fun BBC or PBS programs about buying and selling antiques.

But auctions aren’t just a way for people to find an old item on sale, or sell an old item for profit. They serve an important and interesting economic system at the business level as well. There are many, many types of auctions, but I’ll go through just a few of them here. Different types of auctions can even be combined to effectively change the results of the auction and bidding war due to the presence of information asymmetry (where one party may know something the other doesn’t).

So, to make the examples I’ll be giving clearer, I’ve chosen to illustrate them a bit unrealistically by using an envelope containing a $20 as the item up for bid. That way, there’s no doubt as to how much the item is worth, even though in real life, the absolute value of the item is seldom known ahead of time, if at all.

  • English auction: This is the auction described above, where participants can openly see each others’ bids. Once a bid for an item is reached that isn’t countered by another bidder, the auction is over. Only the winning bidder pays the amount he bid for the item. Another name for this type of auction in economics is the “ascending-bid auction.”

    Example: Suppose I announce that I have an envelope with a $20 bill inside that I’m auctioning. People start bidding for it, maybe starting with $1. Others are willing to pay $5 for the $20 bill, etc. Pretty soon, someone might be willing to pay something close to $20 for that bill, say $19.50. If most people are rational, it’s unlikely that someone would be willing to bid higher than $20 for the $20 bill, let’s suppose the bidding stops at $19.50. The bidder of that amount pays me $19.50 and walks off with the $20.

  • Dutch auction: In this type of auction, the selling price for a large amount of the same item is determined by the market (or bidders at an auction). The auction begins with a suggested, usually high price for the entire lot that descends until it reaches a price point at which a bidder is interested in buying at least a partial number of the item. This auction is also known as a “descending-bid auction”.

    On eBay, these are known as Multiple Item Listings. Other real-life examples include Google’s IPO auction. Recall that the company first opened bidding to investors, who entered their bids in the form of “Y number of shares at $X price”. Google then took these bids and set a clearing price for which all their shares could be sold, which turned out to be $85. At that point, all the bidders who bid at least that amount got to buy Google stock up to the amount of shares they specified, with the ones who bid the highest amounts getting their orders filled first. The US Treasury department also raises funds using this type of auction.

    Example: I announce that have 10 envelopes with $20 each in them. I ask $200 for the lot of them (or $20 each). Instead, you bid $19 for 8 of the envelopes, and another guy bids $5 for 10 envelopes. At this point, all 10 of the available envelopes can be sold: someone was willing to pay $19 for 8 of them, leaving me two, for which someone was willing to pay me $5. But, that’s not how I end up doling out the winnings. Instead, everyone who bid $5 or above will get their orders filled, at least partially, at the $5 price. And I fill your order first, because you bid higher than the other guy, so you get 8 envelopes at $5, and he only gets the two remaining ones for $5.

  • Sealed-bid auction: Under this scenario, all bidders submit sealed bids at the same time to the seller or auctioneer. No other bidder knows how much another one bid. Under the “first-price” version of this type of auction, and the highest bidder wins the item. Under the “second-price” version, the highest bidder wins the item, but pays the price bid by the second-highest bidder. Why would someone want to set up a second-price auction? It turns out that this extra bit of convolution creates an incentive for bidders to bid the real price they would be willing to pay for the item, which benefits the seller. In first-price auctions, the highest bidder just walks away with the prize, and he may have gotten it for less than he was actually willing to pay.

    Example: Yet again, I announce that have an envelope with $20. I setup a sealed first-price auction and receive sealed bids from 3 people. Person A bids $1, Person B bids $5, and Person C bids $10. Person C wins and walks away with a gain of $10. Now, I setup a sealed second-price auction and again receive sealed bids from 3 people. What’s the difference? The bidders know that the winner will walk away with the $20 but paying the amount of the second-highest bidder. So what should they do? Bid the amount they’re willing to pay for $20. Person A might now think that $1 was unreasonable and up his bid to $10. (He looks for values and always wants a discount on everything he buys.) Person B bids $19. Person C’s willing to bid up to $21, thinking that no one else will bid above $20, and he’ll walk away with the $20 at whatever price the second-highest amount was bid. Person C wins again, this time walking away with a gain of $1.

    But you can imagine that if Person B had the same logic, people would start to overpay for $20, I would gain even more as a seller, and winner’s curses would start to be felt (perhaps even moreso if I hadn’t announced how much was in the envelope). Regardless, you can see that in the second-price auction, each bidder is more inclined to bid a higher amount than in the sealed first-price auction setup.

Can you think of any real-life examples that mimic this sort of behavior?

Let’s say I again have $20 to auction off, but this time we’re raising money for charity, so I setup a sealed second-price auction. The highest-bidder again will walk away with the $20 envelope at the price of the second-highest bidder. But I stipulate that the bidder of the second-highest price will also have to pay that amount and receive nothing. (Hey, it’s for charity.) The bidders bid as in the example above: A bids $10, B bids $19, and C bids $21. So C walks away with a gain of $1, but B loses $19.

This simplistic example describes what often happens with companies with high R&D costs, such as pharmaceutical and biotechs. In these industries, companies invest billions of dollars in trying to find cures and new drugs to treat diseases, but often there is only one winner who receives a patent (the right to manufacture and sell the drug) for a set number of years. The rest lose the money they invested, have no drug, and nothing to sell.

There is one more type of auction, called a “reverse auction”, that I’ll cover separately in the coming few days. This one deserves a separate post not only because this one is getting far too long, but because it has a definite application in corporate finance and business. I can’t take credit for everything written here: we ran through these examples and others at a basic Microeconomics class in b-school (with all proceeds going to charity), but if you enjoyed these, you might also enjoy learning about game theory as well.


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