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Lecture 8 – Tom Holden Intermediate Microeconomics Semester 2

ECO2051 – Intermediate Microeconomics


Introduction to Auctions
• Auctions are another solution to an AI problem. • The seller wants to charge the maximum willingness to pay, but does not know what this level is.
• A form of price discrimination.

• A well designed auction encourages the buyer (bidder) to reveal their willingness to pay. • Auctions are most commonly used where there are a few items of high value to sell.

ECO2051 – Intermediate Microeconomics


Auctions reading
• Chapter 17 in Varian.
• MKR have a sub-section in the AI chapter, but it’s not very detailed.

• Klemperer, P. (2001) ‘Why every economist should learn some auction theory.’

• Milgrom, P. (1989) ‘Auctions and Bidding: A Primer’ Journal of Economic Perspectives


• Dustmann and Borgers (2005) ‘Strange Bids: Bidding Behaviour in the United Kingdom’s Third Generation Spectrum Auction’ Economic Journal

• Thaler, R. (1988) ‘Anomalies: The Winner’s Curse’ Journal of Economic Perspectives.

• Roth and Ockenfels (2002) ‘Last-Minute Bidding and the Rules for Ending Second-Price Auctions: Evidence from eBay and Amazon Auctions on the Internet’ American Economic Review.
ECO2051 – Intermediate Microeconomics


Auction design • Two factors to consider when evaluating auctions: • Profit maximisation • Is the seller achieving the maximum price? • Pareto efficiency • Is the good going to the bidder who values it the most? ECO2051 – Intermediate Microeconomics 4 .

buying truffles. • Valuations across individuals are non-independent. but not perfectly correlated. if individual A learns that individual B values the good highly. In a private value set-up.Theoretical frameworks for valuations • Private values • • • • • Each bidder knows what the good is worth to him/herself. but this value is unknown. • E. • Half-way between the two previous cases. individual A’s valuation is unchanged by learning individual B’s valuation. • Signals are not common knowledge. buying an oil field. E. Individuals’ valuations are not common knowledge.g. • In a common value setting. • Each bidder receives some noisy private signal about this true value. then individual A will increase their valuation of the good. • Common values • There is a unique “true” value for the item (perhaps its resale value). ECO2051 – Intermediate Microeconomics 5 • Affiliated values .g. Valuations are different across bidders.

Example • Imagine a painting is auctioned. • How much does the painting sell for? ECO2051 – Intermediate Microeconomics 6 . • Auction is the usual Sotheby’s type where individuals shout out their bids and the highest ‘wins’. • There are four individuals with private valuations of 10. 60 and 100. 40.

can break the equivalence. entry deterrence etc. • The good is then sold to the highest bidder at the last bid they made. • The auctioneer collects up the bids and the good goes to the highest bidder.Auction types (1/3) • English (or ascending) auction: • The auctioneer begins with a reserve price. ECO2051 – Intermediate Microeconomics 7 . • These two auctions are equivalent in many circumstances. • Second-price sealed-bid auction (Vickrey auction): • Each individual writes down their bid without knowledge of what others are bidding. who pays the second highest price bid. • Bidders call out a price until only one bidder remains. information revelation. • Collusion.

• First-price sealed-bid auction: • Each individual writes down their bid without knowledge of what others are bidding. • The auctioneer collects up the bids and the good goes to the highest bidder for the price they bid.Auction types (2/3) • Dutch auction: • The auctioneer starts with a high price and then brings the price down progressively until a bidder calls out and claims the good at that price. ECO2051 – Intermediate Microeconomics 8 . • These two auctions are also usually equivalent.

ascending version of this auction is also possible. • This type of auction is rare with money. ECO2051 – Intermediate Microeconomics 9 . • Again. who gets the item. • An unsealed. • This process is repeated until there is only one person left. • If more than one person was interested. regardless of whether their bid was the highest. • The person who bid the most wins the item.Auction types (3/3) • (Sealed) All pay auctions: • Everyone pays their bid. the auctioneer collects another £1 from everyone still interested. but many “wars of attrition” have this form. • The auctioneer collects £1 from everyone interested in the item. these two auctions are usually equivalent.

Bidding strategy with independent values: English and second price auctions • Optimal to bid your valuation. It’s optimal then to choose your bid so that you win the item whenever 𝑣 > 𝑏 ∗ . bidders bid their valuation. suppose the highest bid by other bidders is 𝑏 ∗ . • To see this. but it will affect the probability of winning. and the price paid is the second-highest valuation. 𝑣. you obtain 0 surplus. Bidding a higher amount will mean you sometimes win and make a negative surplus. If you bid 𝑣. • Deviating from 𝑣 will not affect the price you end up paying (which is determined by the second highest valuation). Your surplus from this is positive providing that 𝑣 > 𝑏 ∗ . • • • • • • You win whenever you make a bid above 𝑏 ∗ . and bidding a lower amount will mean you sometimes lose when you could have won. then you will indeed win whenever 𝑣 > 𝑏∗ . ECO2051 – Intermediate Microeconomics 10 . • With either type of auction. If you don’t win.

• With more bidders. • Thus you want to trade off the probability of winning. since surplus is just your valuation minus your bid. bids will be nearer true valuations. ECO2051 – Intermediate Microeconomics 11 . under a first price auction.Bidding strategy with independent values: Dutch and first price auctions • Optimal to ‘shade’ your bid. and bid below your valuation. as you would expect. and had you won that auction. • Optimal strategy is to bid your expectation of what you would have paid had a second price auction been run instead. although you will win often. • How much below the valuation it is will depend on how many bidders there are. • This is why attracting bidders is an important element of auction design. when you do win you will gain zero surplus. • If you bid your valuation. • Justification for this will be seen shortly. with the amount you obtain when you win. • This is an increasing function of valuations.

• The auction will be an all pay one though. last night. ECO2051 – Intermediate Microeconomics 12 . so everyone who participates will pay their bid.Bidding strategy with independent values: All pay auctions • How do you think people should bid in an all pay auction? • Let’s run an experiment to see what you think. fold it over. write down your name and your bid on a scrap of paper. and pass it to the end of your row. The amount in that email is the amount you’ll win if you win the auction. • You should have all received an email with a secret amount of money in it. • If you want to participate.

any “reasonable” mechanism for allocating goods will generate the same expected revenue for the seller. • It is this that means that in the first price auction. bidders will optimally bid what they would have paid had a second price auction been run instead (and had they won that auction).The revenue equivalence theorem (1/2) • The revenue equivalence theorem is a general result stating that given certain technical assumptions. so the revenue equivalence theorem is satisfied. ECO2051 – Intermediate Microeconomics 13 . • This ensures that the seller’s revenue is the same in both first price and second price auctions.

• (ii) the bidder with the lowest possible type/valuation/signal expects zero surplus. • The winning bid should be epsilon above the second highest valuation. • (iii) all bidders are risk neutral and • (iv) all bidders are drawn from a strictly increasing and atomless distribution • will lead to the same expected revenue for the seller (and player 𝑖 of type 𝑣 can expect the same surplus across auction types).The revenue equivalence theorem (2/2) • “…any allocation mechanism/auction in which • (i) the bidder with the highest type/signal/valuation always wins.” (Source: Wikipedia) .

Diversion: Product patent races • Suppose 𝑛 risk-neutral firms compete to invent a new product. Π]. • Each firm’s profits if they are a monopolist are drawn uniformly at random from the interval [0. • Firms know their own profit draws. but not those of their rivals. • The firm that performs the most units of research will win the patent race. • The inventor of the product will be granted a patent. • Firms differ in their costs to produce the product if they invent it. . enabling them to extract some monopoly profits. and thus differ in the amount of monopoly profits they would receive.

• (iii) and (iv) holds by assumption. • Valuations = profits if they invent the product. • (ii) holds because the lowest type of firm makes zero profits if they win. • So the RET holds. • Check each point in turn: • (i) holds as the amount of research firms will want to do will be increasing in their profits if they win. .Applying the RET to our patent race model (1/4) • Bidders = firms.

𝑛+1 • The expected 𝑘 th highest draw out of 𝑛 from a uniform distribution 𝑛+1−𝑘 on the interval 𝑎. 𝑛+1 • E.Useful fact • The expected 𝑘 th lowest draw out of 𝑛 from a uniform distribution on 𝑘 the interval 𝑎. ECO2051 – Intermediate Microeconomics 17 .g. 𝑏 is 𝑎 + 𝑏 − 𝑎 . 𝑏 is 𝑎 + 𝑏 − 𝑎 . the expected highest is 𝑎 + 𝑛 𝑛+1 𝑏 − 𝑎 .

• Consider this alternative mechanism (the ascending auction AKA the second-price auction): • Sells the good at the second highest valuation. 𝑛+1 Π.e. 𝑛−1 i. and hence their bids. . • Immediately from the RET we have that the total amount of research performed by all firms is given by the expected second highest profit draw.Applying the RET to our patent race model (2/4) • Given the RET holds. we can derive firms expected surplus.

it may be shown that the other 𝑛 − 1 draws are uniform on 0. conditional on the original firm’s valuation being the highest. times Π minus the expected valuation of the second highest bidder. Π .Applying the RET to our patent race model (3/4) • Suppose then that a firm would make profits of Π if they were a monopolist. • Conditional on the highest of the 𝑛 draws being Π. • What is the probability that Π is the highest draw? It is the probability that 𝑛−1 the 𝑛 − 1 other draws were below Π.e. the second highest overall) is expected to be at 𝑛 Π. i.e. • Hence the firm’s expected surplus is Π 𝑛−1 Π Π− 𝑛−1 Π 𝑛 = 𝑛−1 Π Π . Thus the highest of these other 𝑛 − 𝑛−1 1 (i. • Their expected surplus under a second price auction is the probability that their valuation is the highest. Π 𝑛 . Π Π .

all minus your research expenditure (which you pay even if you do not win the race).Applying the RET to our patent race model (4/4) • So how much research should they do? • Expected surplus under the patent race is the probability that you have the highest profit draw times your profit draw. • By the RET. this expected surplus must equal the expected surplus from the 𝑛−1 𝑛−1 Π ascending auction. hence 𝑛 Π Π = ΠΠ Π − 𝑟 Π . where 𝑟 Π is the research expenditure of a firm that drew Π.e.e. so performing near zero amounts of research is optimal. 𝑟 Π = Π Π 𝑛−1 Π − 𝑛 = Π 𝑛−1 𝑛−1 Π Π . . Π Π 𝑛−1 Π − 𝑟 Π . • I. Π 𝑛 𝑛−1 • For even moderately large 𝑛. Π Π will be tiny for all but the very highest Π. • I.

• With risk aversion. since they prefer winning a small surplus with a high probability to winning a larger surplus with low probability. ECO2051 – Intermediate Microeconomics 21 . • First price auctions are thus likely to lead to higher revenue in the presence of risk aversion. people will bid higher in first price auctions compared to the risk neutral benchmark.Risk aversion • Risk aversion removes the revenue equivalence of first and secondprice auctions.

• Expected revenue is £33. and once he will not sell. 11. but is often Pareto inefficient. • Optimal to make a take it or leave it offer that has a positive probability of being rejected. seller thinks each has a value of £10 or £100. and ties are resolved by flipping a coin. • With a reserve price of £100: • In three cases the seller will get £100. • Varian example: • • • • 2 bidders. 11.10) (100. Seller runs an ascending auction with a £1 increment. • Or consider the case with only one bidder. Possible combinations are (10. (100. 100) (depending on which state of the world we’re in). (10. ECO2051 – Intermediate Microeconomics 22 . With no reserve price: • The good will go to the bidder with the highest value.Optimal reserve prices • Setting an appropriate reserve price can lead to an increase in profit.10).100).100). • Expected revenue is £75. • The price will be (10.

Myerson: Optimal auction design • In the special case in which valuations are independent across bidders. and they are drawn from a common distribution satisfying a technical requirement (“regularity”). sealed-bid auction in which the seller first announces an (optimally chosen) reserve price. • More generally. the optimal auction is a second price. we can define a notion of “marginal revenue” (see the Klemperer paper) under which the auctioneer should sell to the buyer with the highest marginal revenue. ECO2051 – Intermediate Microeconomics 23 .

) • Everyone else keeps their money. so it certainly makes sense to set 𝑏𝑖 > 𝑥𝑖 . then they are guaranteed a positive value. Participant 𝑖 bids 𝑏𝑖 . • What have we learned? ECO2051 – Intermediate Microeconomics 24 . and pays the final bid with which they won. The winner receives this amount. 𝑛 participants. if participant 𝑗 wins. from the auctioneer. Participant 𝑖 has 𝑥𝑖 in their wallet. • I. • If the winner just bid the contents of their own wallet.e. (If this is negative they must pay the auctioneer.Common values • Let’s auction the contents of some of your wallets! • • • • English auction. but all debts must be settled in full one way or another. They are allowed to bid more than 𝑥𝑖 . • Total in all of the wallets is 𝑣 ≔ 𝑛 𝑖=1 𝑥𝑖 . they get 𝑣 − 𝑏𝑗 = 𝑛 𝑖=1 𝑥𝑖 − 𝑏𝑗 .

those who win will always be those who had the highest valuations. • If people stay in the auction until the price is equal to their expected valuation. and suffer the winner’s curse.The winner’s curse • This occurs in a common value framework. • As bids are a consequence of estimated valuations. • Shading will be greater if there are more bidders. • Rational bidders shade their bids to avoid the curse. • The English auction is no longer equivalent to the second-price sealed-bid auction. • I care about the value of the item conditional on me winning. it’s worse to be the highest of many bidders. ECO2051 – Intermediate Microeconomics 25 . as the extra information modifies the impact of the winner’s curse. they will over-bid.

• This raised £26. • 2G licenses had been disposed of by beauty contest and had raised £40.Example of a common value auction: 3G spectrum • In Spring 2000 5 radio licenses to operate third-generation mobile phone systems were auctioned in the UK.000. • The auction was overseen by a team of academics acting as consultants: ‘But perhaps the most important lesson of all was not to sell ourselves too cheap. Ideas that seem obvious to a trained economist are often quite new to layfolk.3 billion or 2.5% of UK GDP.’ ECO2051 – Intermediate Microeconomics 26 . Our marginal product in preventing mistakes can therefore sometimes be surprisingly large.

The mechanics of the 3G auction • ‘Simultaneous ascending price auction’. ECO2051 – Intermediate Microeconomics 27 . 3 small. 2 large. • All licenses are auctioned at the same time. • Auction only ends when bidding on all licenses has stopped. 150 rounds of bidding. One large was reserved for an entrant in recognition of competition issues. • Auction took almost 8 weeks. • All bidders must bid in each round (a few waivers permitted). • 5 licenses auctioned.

Bidders ECO2051 – Intermediate Microeconomics 28 .

Winners ECO2051 – Intermediate Microeconomics 29 .

• Many that followed were a disaster. • Some evidence of first-mover advantage. But the auction designs deserves neither praise nor blame if the values placed on the 3G licenses have now fallen because of a change in the capital market’s view of 3G’s prospects.’ • There could be an element of ‘winner’s curse’ here too.The outcome – luck or judgement • The UK auctions were seen as among most successful in Europe. confidence in hi-tech industries in general has waned since that time. ECO2051 – Intermediate Microeconomics 30 . • Binmore and Klemperer: ‘Of course.g. Turkish. Dutch. • Klemperer argues that attention to industrial organization issues was crucial. e.

• Mixed results for competition: • More effective competition for EE from an enlarged Vodafone. ECO2051 – Intermediate Microeconomics 31 . • But the existing smaller players (O2 and 3) both shrunk in relative size after the auction. • “Low” revenue is being investigated by the National Audit Office. • Recall that the 3G one raised £26.The sequel: The 4G spectrum auction • Raised £2. which was £1.3 billion.2 billion less than the treasury expected.3 billion. • BT was a new entrant.

• Hypothesise ‘straightforward bids’ • Bidders enter the auction with fixed valuations for each license.Did the bidders behave rationally? (1/2) • Investigated by Borgers and Dustmann. • They always bid the minimum increment. • Bidders drop out once the maximum surplus is negative. ECO2051 – Intermediate Microeconomics 32 . • They will bid for the license which offers the highest current surplus (the one for which the gap between the valuation and the current highest bid is greater).

Did the bidders behave rationally? (2/2) • If we observe a firm bidding for a given license. we can deduce that in this round. which goes against Klemperer’s idea that good design alone led to high prices. • Example: Orange only bid for license E. the price difference must be less than the difference in valuations for this firm. this is only rational if Orange perceived E to be much more valuable than the other small licenses. ECO2051 – Intermediate Microeconomics 33 . • If the smaller licenses were identical you would expect firms to always bid for the cheaper license. say A rather than a cheaper license B. • Some evidence of irrational bidding.

Bidding by Orange – makes sense Source: Borgers and Dustmann ECO2051 – Intermediate Microeconomics 34 .

ECO2051 – Intermediate Microeconomics 35 . who explains BT strategy in terms of common values. EJ 2005. Maldoon. Or drive up the price paid by Vodaphone.Bidding by BTcellnet – seems irrational There’s an interesting paper. Switching was an attempt to confuse competitors.

ECO2051 – Intermediate Microeconomics 36 . the bidder with the highest valuation will win but at the second highest bid (plus minimum increment).Online auctions • You bid on an Ebay auction by inserting a maximum bid. • The auction proceeds by using a proxy bidder who raises your bid as necessary by the minimum increment provided it doesn’t exceed your maximum. • This is very close to a second-price auction.

no one wishes to reveal their valuation. • Early bids make it likely that you will be bid right up to true valuation. Late bidding or ‘sniping’ is extremely common.Late bidding • The analysis of the second price auction implies that people will make straightforward bids and reveal their true valuation early on. as it could drive the final price up. ECO2051 – Intermediate Microeconomics 37 . • Two explanations: • If there is an element of common value. late bidding adds an element of randomness which might be better for bidders on average. • In practice this does not happen.

Worth having a reserve price and minimum bid (but there’s a chance you won’t sell). Prasad. Only negative feedback affects selling prices. Longer auctions lead to higher prices.” Journal of Industrial Economics. Weekend closes good. ECO2051 – Intermediate Microeconomics 38 . (2007) “Pennies from eBay: the Determinants of Price in Online Auctions. • • • • • From data on selling US 1 cent coins. Bryan. Reeves. • More bidders are good (probably why longer and weekend auctions increase selling price).Other results on eBay auctions • Lucking-Reiley.

Advantages of auctions • Auctions are generally efficient. • But auctions are expensive to run. • As we have seen. (AI again) • From the seller’s point of view. they are the most effective way of gaining surplus. ECO2051 – Intermediate Microeconomics 39 . but here you must ‘put your money where your mouth is’. • Transparent – particularly important for Govt. auctions do this. so not suitable for all goods. it’s easy to say you value the good the most. • In beauty contests. We want to allocate the good to the bidder who values it most.