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Problem Set 5: Auctions

1. Charlie Plopp (blame Varian) sells used construction equipment. He needs to raise some money. He wishes to sell an old bulldozer today, otherwise he will sell it to a wholesaler tomorrow for £1000. There are two types of people interested in buying bulldozers, professional bulldozer operators and recreational bulldozer users (?!). Charlie knows that professionals will be prepared to pay £6000, amateurs will pay up to £4500. Charlie attracts two bidders to his sale, each has a 0.5 chance of being a professional and a 0.5 chance of being an amateur. There are three possible ways of selling the bulldozer. A. Post a price of £4,500, if no one is prepared to pay, take the bulldozer to the wholesaler. B. Post a price of £6,000, if no one is prepared to pay, take the bulldozer to the wholesaler. C. Hold a second price sealed bid auction. (If there is a tie, flip a coin to determine the winner, who will pay the price he bid). Calculate the expected revenue of each of the selling methods to help Charlie choose which to use. HINT: There are four possible combinations of willingness to pay, for each method work out the revenue under each combination.

2. Four firms A, B, C and D bid for an oil drilling contract. Firm A expects the oil will be worth £2.5m, firm B expects it will be worth £3m, Firm C values it at $3.5m and firm C values it at £4m. A second price sealed-bid auction is used to allocate the drilling rights. Do we know how much each bidder will bid? Explain why. How will bids change if another bidder enters the auction?

3. As many of you will know, e-bay bidders can enter a maximum bid. If a bidder does not hold the highest bid the website automatically increases their bid by a 50p increment until the maximumbidis reached. Is it optimal to set the maximum bid equal to your true valuation? Why?

4. Five (risk-neutral) countries are staking a claim to a patch of the arctic, believed to be rich in oil. Each country has sent a small army team to keep watch and make sure that none of the other countries put up military fortifications, or begin drilling. Suppose that maintaining these army teams costs each country £100 million per year. Were all but one of the countries’ teams to leave, the remaining country would then be able to defend the territory forever, earning it a pay -out (the oil revenue). Suppose that each country has a valuation for the future oil revenue drawn from a uniform distribution from £0 to £240,000 million (perhaps they are each using different surveying technology). By using the revenue equivalence theorem, calculate how long (in expectation) the countries will keep their teams in the arctic. (Hint: this is an all pay auction.)