Chapter 11

Auctions

1
 Sealed-Bid Auctions with
Complete Information
 2-bidder auctions as matrix games
 The 3 principles of bidding
 The relationship of auction equilibrium to
Bertrand equilibrium

2
 Bidding Principle 1

Never overbid. As a strategy,

overbidding is dominated by
bidding zero.

3
 Bidding Principle 2

If you know you are the high-bidder

in a first-price auction, you should
always shave your bid.

4
 First-Price auction, $1 bidding
interval: deriving the payoffs
z1 = 2 and z2 = 1
When, b1 = $2 and b2 = $1,
u1 = 2 - 2 = 0 and u2 = 0
When, b1 = $1 and b2 = $1,
u1 = .5  (2 - 1) + .5  0 = 0.5 and
u2 = .5  (1 - 1) + .5  0 = 0
When, b1 = $0 and b2 = $1,
u1 = 0 and u2 = 1 - 1 = 0
5
 First-Price auction, $1 bidding
interval: deriving the payoffs
When, b1 = $2 and b2 = $0,
u1 = 2 - 2 = 0 and u2 = 0
When, b1 = $1 and b2 = $0,
u1 = 2 - 1 = 1 and u2 = 0
When, b1 = $0 and b2 = $0,
u1 = .5  (2 - 0) + .5  0 = 1 and
u2 = .5  (1 - 0) + .5  0 = 0.5

6
First-Price auction, $1 bidding interval
Player 2
Player 1 b2= $1 b2= $0

b1= $2 0, 0 0, 0

b1= $1 0.50, 0 1, 0

b1= $0 0, 0 1, 0.50
7
First-Price auction, $1 bidding interval:
strategy for player 1
Player 2
Player 1 b2= $1 b2= $0

b1= $2 0, 0 0, 0

b1= $1 0.50, 0 1, 0

b1= $0 0, 0 1, 0.50
8
First-Price auction, $1 bidding interval:
strategy for player 2
Player 2
Player 1 b2= $1 b2= $0

b1= $2 0, 0 0, 0

b1= $1 0.50, 0 1, 0

b1= $0 0, 0 1, 0.50
9
First-Price auction, $1 bidding interval:
three pure strategy equilibria
Player 2
Player 1 b2= $1 b2= $0

b1= $2 0, 0 0, 0

b1= $1 0.50, 0 1, 0

b1= $0 0, 0 1, 0.50
10
First-Price auction, $0.5 bidding
interval
Player 2
Player 1 b 2 = $1 b2= $0.5 b2= $0

b1= $1.5 0.5, 0 0.5, 0 0.5, 0

b1= $1 0.5, 0 1, 0 1, 0

b1= $0.5 0, 0 0.75, 0.25 1.5, 0

11
First-Price auction, $0.5 bidding
interval: strategy for player 1
Player 2
Player 1 b 2 = $1 b2= $0.5 b2= $0

b1= $1.5 0.5, 0 0.5, 0 0.5, 0

b1= $1 0.5, 0 1, 0 1, 0

b1= $0.5 0, 0 0.75, 0.25 1.5, 0

12
First-Price auction, $0.5 bidding
interval: strategy for player 2
Player 2
Player 1 b 2 = $1 b2= $0.5 b2= $0

b1= $1.5 0.5, 0 0.5, 0 0.5, 0

b1= $1 0.5, 0 1, 0 1, 0

b1= $0.5 0, 0 0.75, 0.25 1.5, 0

13
First-Price auction, $0.5 bidding
interval: three pure strategy equilibria
Player 2
Player 1 b 2 = $1 b2= $0.5 b2= $0

b1= $1.5 0.5, 0 0.5, 0 0.5, 0

b1= $1 0.5, 0 1, 0 1, 0

b1= $0.5 0, 0 0.75, 0.25 1.5, 0

14
First-Price auction, bidding interval :
z1  z2 and  is very small
Player 2
Player 1 b2 = z 2 b2= z2 + 

b1= z2 +  z1 - z2 - , 0 z1 - z2 - , 0

b1= z2 (z1 - z2)/2, 0 z1 - z2, 0

0, 0 (z1 - z2 - )/2,
b1= z2 - 
/2
15
First-Price auction, bidding interval :
strategy for player 1
Player 2
Player 1 b2 = z 2 b2= z2 + 

b1= z2 +  z1 - z2 - , 0 z1 - z2 - , 0

b1= z2 (z1 - z2)/2, 0 z1 - z2, 0

0, 0 (z1 - z2 - )/2,
b1= z2 - 
/2
16
First-Price auction, bidding interval :
strategy for player 2
Player 2
Player 1 b2 = z 2 b2= z2 + 

b1= z2 +  z1 - z2 - , 0 z1 - z2 - , 0

b1= z2 (z1 - z2)/2, 0 z1 - z2, 0

0, 0 (z1 - z2 - )/2,
b1= z2 - 
/2
17
First-Price auction, bidding interval :
two pure strategy equilibria
Player 2
Player 1 b2 = z 2 b2= z2 - 

b1= z2 +  z1 - z2 - , 0 z1 - z2 - , 0

b1= z2 (z1 - z2)/2, 0 z1 - z2, 0

0, 0 (z1 - z2 - )/2,
b1= z2 - 
/2
18
 First-price auction as a market
P
Supply

z1
Market equilibrium,
Auction equilibrium
z2

Demand

Q
1 2 19
 Bidding Principle 3

If you have the high valuation in a

first-price auction, you should bid as
close to the second-highest bidder as
the bidding interval allows.

20
 Second-Price Auctions
 Two types of sealed-bid auctions, first-
price and second-price
 Second-price auctions remove the
incentive to underbid
 Unique solution in true values

21
 Second-price auction, $1 bidding interval
Player 2 b = $3 b2 = $2 b2 = $1 b2 = $0
2
Player 1
b1 = $3 -0.5, -1 0, 0 1, 0 2, 0

b1 = $2 0, -1 0, -0.5 1, 0 2, 0

b1 = $1 0, 0 0, 0 0.5, 0 2, 0

b1 = $0 0, 1 0, 1 0, 1 1, 0.5
22
 Bidding Principle 4

In a second-price auction, always bid

true value.

23
 Individual Private Value
Auctions
 The private value assumption
 The probability of having the highest value
 Shaving one’s bid for optimal expected
payoff
 Monotonic bidding functions
 Perfect competition as the limit of an
auction

24
 Three monotonic bid functions
b1
100 b1 = z1

b1 = z1/2

b1 = z1
0
z1
40 80 100
25
 Uniform distribution of valuations
Probability

0.01

0
z1
40 80 100
26
 Individual Private Value Auctions
with risk-neutral players
EV1 = p1(win) (z1 - b1) + p1(lose)  0 = p1(win) (z1 - b1)
Suppose, p1(win) = kb1
With two bidders, EV1 = kb1(z1 - b1)
First Order Condition, EV1/b1 = 0
 0 = kb1  -1 + k(z1 - b1)  b1(z1) = z1/2
With three bidders, p(1 wins against two rivals)
= p(1 wins against rival 1)  p(1 wins against rival 2)
= p1(win)2 = (kb1)2
27
 Individual Private Value Auctions
with risk-neutral players
With n bidders, p(1 wins against n - 1 rivals) = (kb1)n-1
 EV1 = (kb1)n-1 (z1 - b1)
First Order Condition, EV1/b1 = 0
 0 = (n - 1) k(kb1)n-2 (z1 - b1) + (kb1)n-1  -1
 0 = (n - 1) z1 + n b1  b1(z1) = (n -1) z1/ n
Taking limit at n  , b1(z1) = z1

28
Individual Private Value Auctions with
risk-averse or risk-seeking players
When both players are risk-averse,
Eu1 = p1(win)  money = kb1  (z1 - b1)
First Order Condition, EV1/b1 = 0
 0 = kb1  .5  (z1 - b1)-.5  -1 + k (z1 - b1)
 b1(z1) = 2z1/3
When both players are risk-seeking,
Eu1 = p1(win)  (money)2 = kb1  (z1 - b1)2
First Order Condition, EV1/b1 = 0
 0 = kb1  2  (z1 - b1)  -1 + k (z1 - b1)2 29
 Auctioning off Failed Thrifts
 The sequel to depositors versus S&L
 RTC auction procedures, especially the
generation of information
 A statistical bidding function
 Mitigating the damage to the Treasury of
the S&L crisis

30
 Common Value Auctions
 Auctions where the underlying value is
unknown
 Transforming a signal into conditional
expected value
 The bid shaving principle for common
value auctions
 The winner’s curse

31
 Generating a noisy signal, table of
maximum values
Bidder 2
signal
Bidder 1 z2 = 1 z2 = 2 z2 = 3 z2 = 4 z2 = 5 z2 = 6
signal
z1 = 1 1 2 3 4 5 6
z1 = 2 2 2 3 4 5 6
z1 = 3 3 3 3 4 5 6
z1 = 4 4 4 4 4 5 6
z1 = 5 5 5 5 5 5 6
z1 = 6 6 6 6 6 6 6
32
 Common-value auctions with two
bidders
Each bidder i can receive either the signal z1 = 1 or z1
= 2 with probability 1/2 and the true value of the item
at auction, v = (z1 + z2)/2
When z1  z2, b1(z1)*  b2(z2)*
When both bidders received the signal zi = 1, there
are two equilibria:
b(1)* = (b1(1)*, b2(1)*) = (.80, .80) and
b(1)* = (.90, .90)
When z1 = 2, z2 = 2 with probability 1/2 and z2 = 1
33
 Common-value auctions, two-bidders
E(v | z1)
E(v | z1) = 1.75 + 0.5z1
4.75

b1(z1) = 0.875 + 0.25z1

2.25

1 2 3 4 5 6 z1
34
Common-Value auction, z1 = 2 is a
maximum signal
Player 2
b2(2)= $1.7 b2(2)= $1.6 b2(2)= $1.5
Player 1

b1(2)= $1.7 -0.25, -0.25 0.05, 0 0.05, 0

b1(2)= $1.6 0, 0.05 0.05, 0.05 0.15, 0

b1(2)= $1.5 0, 0.05 0, 0.15 0.125, 0.125

35
Common-Value auction, z1 = 2 is a
maximum signal: strategy for player 1
Player 2
b2(2)= $1.7 b2(2)= $1.6 b2(2)= $1.5
Player 1

b1(2)= $1.7 -0.25, -0.25 0.05, 0 0.05, 0

b1(2)= $1.6 0, 0.05 0.05, 0.05 0.15, 0

b1(2)= $1.5 0, 0.05 0, 0.15 0.125, 0.125

36
Common-Value auction, z1 = 2 is a
maximum signal: strategy for player 2
Player 2
b2(2)= $1.7 b2(2)= $1.6 b2(2)= $1.5
Player 1

b1(2)= $1.7 -0.25, -0.25 0.05, 0 0.05, 0

b1(2)= $1.6 0, 0.05 0.05, 0.05 0.15, 0

b1(2)= $1.5 0, 0.05 0, 0.15 0.125, 0.125

37
Common-Value auction, z1 = 2 is a maximum
signal: three pure strategy equilibria
Player 2
b2(2)= $1.7 b2(2)= $1.6 b2(2)= $1.5
Player 1

b1(2)= $1.7 -0.25, -0.25 0.05, 0 0.05, 0

b1(2)= $1.6 0, 0.05 0.05, 0.05 0.15, 0

b1(2)= $1.5 0, 0.05 0, 0.15 0.125, 0.125

38
 Bidding for Offshore Oil
 Government leases of
 The common value assumption in offshore
oil
 Positive industry returns, some negative
company returns

39
 Appendix. Auctions in the
Laboratory
 Individual private value auction
experiments
 Common value auction experiments
 Evidence in the winner’s curse
 Lingering laboratory mysteries

40
 Bidding function of a typical subject

The bid function for a risk-neutral player,

bi(zi) = 0.67 zi
The bid function that best fits the data,
bi(zi) = a + bzi where a  0, 1  b  0
Break-even bidding,
bi(zi) = zi

41
 Bidding function of a typical subject
bi a0
0.67  b1  0

bi = z i
bi = a + bzi

bi = 0.67zi

zi
42