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Auction theory
From Wikipedia, the free encyclopedia

Auction theory is an applied branch of game theory which deals with how people act in auction markets
and researches the game-theoretic properties of auction markets. There are many possible designs (or sets
of rules) for an auction and typical issues studied by auction theorists include the efficiency of a given
auction design, optimal and equilibrium bidding strategies, and revenue comparison. Auction theory is
also used as a tool to inform the design of real-world auctions; most notably auctions for the privatisation
of public-sector companies or the sale of licenses for use of the electromagnetic spectrum.

Contents
 1 General Idea
 2 Types of auction
 3 Game-theoretic models
 4 Revenue Equivalence
 5 Winner's curse
 6 JEL Classification
 7 Footnotes
 8 Further reading
 9 External links

General Idea
Auctions take many forms but always satisfy two conditions:

(i) They may be used to sell any item and so are universal, also

(ii) The outcome of the auction does not depend on the identity of the bidders; i.e., auctions are
anonymous.

Most auctions have the feature that participants submit bids, amounts of money they are willing to pay.
Standard auctions require that the winner of the auction is the participant with the highest bid. A
nonstandard auction does not require this (e.g. a lottery).

Types of auction
There are traditionally four types of auction that are used for the allocation of a single item:

 First-price sealed-bid auctions in which bidders place their bid in a sealed envelope and
simultaneously hand them to the auctioneer. The envelopes are opened and the individual with the
highest bid wins, paying a price equal to the exact amount that he or she bid.
 Second-price sealed-bid auctions (Vickrey auctions) in which bidders place their bid in a sealed
envelope and simultaneously hand them to the auctioneer. The envelopes are opened and the
individual with the highest bid wins, paying a price equal to the exact amount of the second highest
bid.
 Open Ascending-bid auctions (English auctions) in which the price is steadily raised by the
auctioneer with bidders dropping out once the price becomes too high. This continues until there

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remains only one bidder who wins the auction at the current price.
 Open Descending-bid auctions (Dutch auctions) in which the price starts at a level sufficiently high
to deter all bidders and is progressively lowered until a bidder indicates that he is prepared to buy
at the current price. He or she wins the auction and pays the price at which they bid.

Most auction theory revolves around these four "standard" auction types. However, other auction types
have also received some academic study, such as:

 All-pay auctions in which bidders place their bid in a sealed envelope and simultaneously hand
them to the auctioneer. The envelopes are opened and the individual with the highest bid wins,
paying a price equal to the exact amount that he or she bid. All losing bidders are also required to
make a payment to the auctioneer equal to their own bid in an all-pay auction. This auction format
is non-standard, but can be used to understand things such as election campaigns (in which bids can
be interpreted as campaign spending) or queuing for a scarce commodity (in which your bid is the
amount of time for which you are prepared to queue).
 Unique bid auctions
 Many homogenous item auctions, e.g., spectrum auctions
 Simultaneous multiple-round auctions
 Position auctions
 Generalized second-price auction

Game-theoretic models
A game-theoretic auction model is a mathematical game represented by a set of players, a set of actions
(strategies) available to each player, and a payoff vector corresponding to each combination of strategies.
Generally, the players are the buyer(s) and the seller(s). The action set of each player is a set of bid
functions or reservation prices. Each bid function maps the player's value (in the case of a buyer) or cost
(in the case of a seller) to a bid price. The payoff of each player under a combination of strategies is the
expected utility (or expected profit) of that player under that combination of strategies.

Game-theoretic models of auctions and strategic bidding generally fall into either of the following two
categories. In a private value model, each participant (bidder) assumes that each of the competing bidders
obtains a random private value from a probability distribution. In a common value model, each
participant assumes that any other participant obtains a random signal from a probability distribution
common to all bidders. Usually, but not always, a private values model assumes that the values are
independent across bidders, whereas a common value model usually assumes that the values are
independent up to the common parameters of the probability distribution.

When it is necessary to make explicit assumptions about bidders' value distributions,


most of the published research assumes symmetric bidders. This means that the
probability distribution from which the bidders obtain their values (or signals) are
identical across bidders. In a private values model which assumes independence,
symmetry implies that the bidders' values are independently and identically
distributed (i.i.d.).

An important example (which does not assume independence) is Milgrom and Ex-post
equilibrium in a
Weber's "general symmetric model" (1982).[1][2] One of the earlier published simple auction
theoretical research addressing properties of auctions among asymmetric bidders is market.
Keith Waehrer's 1999 article.[3] Later published research include Susan Athey's 2001
Econometrica article,[4] as well as Reny and Zamir (2004).[5]

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In a simple first-price auction model with two buyers are bidding for an object, each
buyer might assume that the rival buyer's private value is drawn from the uniform
distribution over the interval [0,1], with the cumulative distribution function
F(v) = v. (Since F is symmetric between the two buyers, this is an auction model
with symmetric bidders.) Assuming that: (i) the value of the object for the seller is 0,
and (ii) the seller's reservation price is also 0,[6] each buyer's expected utility U as a
Examples of
function of his/her bid price p is equal to the consumer surplus that the buyer will strategies (bid
functions)
receive conditional on winning (v − p), multiplied by the likelihood that he or she available to
is going to be the buyer with the highest bid price. That likelihood is given by the either buyer.

probability that this buyer's bid price p exceeds the other buyer's bid price B
(expressed as a function of the other buyer's value vo). Express this probability as Pr{p > B(vo)}.
Then, U(p) = (v − p)Pr{p > B(vo)}. Assume that each buyer's equilibrium bid price is
monotonically increasing in that buyer's value; this implies that the bid function B has an inverse
function. Let Y be the inverse of B: Y = B − 1. Then U(p) = (v − p)Pr{Y(p) > vo}.
Since vo is distributed F(vo), Pr{Y(p) > vo} = F(Y(p)) = Y(p), which implies

U(p) = (v − p)Y(p). A bid price p maximizes U if U'(p) = 0. Differentiating U with respect to p


and setting to zero, . Since the buyers are symmetric, in
equilibrium it must be the case that p = B(v) or (equivalently) Y(p) = v. Therefore
. A solution of this differential equation is an inverse Nash
equilibrium strategy of this game.

At this point, one may conjecture that the (unique) solution is the linear function and
for some real number a. Substituting into ,− ap + (ap − p)a = 0 or
− p + (a − 1)p = 0. Solving for a yields . Therefore satisfies .
implies , or . Thus, the (unique) Nash equilibrium strategy
bidding function of this game is established as , at least within the set of invertible bidding
functions. Lebrun (1996)[7] provides a more general proof that an equilibrium exists in a first-price
auction when the random valuations of the bidders are independent of each other.

Revenue Equivalence
One of the major findings of Auction Theory is the celebrated Revenue Equivalence Theorem, which
states that any allocation mechanism/auction in which (i) the bidder with the highest type/signal/value
always wins, (ii) the bidder with the lowest possible type/value/signal expects zero surplus, (iii) all
bidders are risk neutral and (iv) all bidders are drawn from a strictly increasing and atomless distribution
will lead to the same revenue for the seller (and player i of type v can expect the same surplus across
auction types). [8]

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Winner's curse
The winner's curse is a phenomenon which can occur in common value settings—when the actual values
to the different bidders are unknown but correlated, and the bidders make bidding decisions based on
estimated values. In such cases, the winner will tend to be the bidder with the highest estimate, and that
winner will frequently have bid too much for the auctioned item.

In an equilibrium of such a game, the winner's curse does not occur because the bidders account for the
bias in their bidding strategies. Nonetheless, models of such auctions can help identify the winner's curse.

JEL Classification
In the Journal of Economic Literature Classification System C7 is the classification for Game Theory and
D44 is the classification for Auctions.[9]

Footnotes
1. ^ Milgrom, P., and R. Weber (1982) "A Theory of Auctions and Competitive Bidding,"
Econometrica Vol. 50 No. 5, pp. 1089–1122.
2. ^ Because bidders in real-world auctions are rarely symmetric, applied scientists began to research
auctions with asymmetric value distributions beginning in the late 1980s. Such applied research
often depended on numerical solution algorithms to compute an equilibrium and establish its
properties. Preston McAfee and John McMillan (1989) simulated bidding for a government
contract in which the cost distribution of domestic firms is different from the cost distribution of
the foreign firms ("Government Procurement and International Trade," Journal of International
Economics, Vol. 26, pp. 291-308.) One of the publications based on the earliest numerical research
is Dalkir, S., J. W. Logan, and R. T. Masson, "Mergers in Symmetric and Asymmetric
Noncooperative Auction Markets: The Effects on Prices and Efficiency," published in Vol. 18 of
The International Journal of Industrial Organization, (2000, pp. 383–413). Other pioneering
research include Tschantz, S., P. Crooke, and L. Froeb, "Mergers in Sealed versus Oral Auctions,"
published in Vol. 7 of The International Journal of the Economics of Business (2000, pp. 201–
213).
3. ^ K. Waehrer (1999) "Asymmetric Auctions With Application to Joint Bidding and Mergers,"
International Journal of Industrial Organization 17: 437-452
4. ^ Athey, S. (2001) "Single Crossing Properties and the Existence of Pure Strategy Equilibria in
Games of Incomplete Information," Econometrica Vol. 69 No. 4, pp. 861-890.
5. ^ Reny, P., and S. Zamir (2004) "On the Existence of Pure Strategy Monotone Equilibria in
Asymmetric First-Price Auctions," Econometrica, Vol. 72 No. 4, pp. 1105–1125.
6. ^ This assumption implies that the seller is not acting strategically; strictly speaking, the seller is
not a player in this example.
7. ^ Lebrun, Bernard (1996) "Existence of an equilibrium in first price auctions," Economic Theory,
Vol. 7 No. 3, pp. 421-443.
8. ^ McAfee, , R Preston; & John McMillan. (1987). "Auctions and Bidding". Journal of Economic
Literature 25 (2).
9. ^ "Journal of Economic Literature Classification System". American Economic Association.
http://aea-web.org/journal/jel_class_system.html. Retrieved 2008-06-25. (D: Microeconomics, D4:
Market Structure and Pricing, D44: Auctions)

Further reading

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 Cassady, R. (1967). Auctions and auctioneering. University of California Press. An influential


early survey.

 Klemperer, P. (Ed.). (1999b). The economic theory of auctions. Edward Elgar. A collection of
seminal papers in auction theory.

 Klemperer, P. (1999a). Auction theory: A guide to the literature. Journal of Economic Surveys, 13
(3), 227–286. A good modern survey; the first chapter of the preceding book.

 Klemperer, Paul (2004). Auctions: Theory and Practice. Princeton University Press. ISBN 0-691-
11925-2. Draft edition available online

 Krishna, Vijay (2002). Auction theory. New York: Elsevier. ISBN 978-0-124-26297-3. A very
good modern textbook on auction theory.

 McAfee, R. P. and J. McMillan (1987), "Auctions and Bidding", Journal of Economic Literature
25: 708–47. A survey.

 Myerson, R. (1981). Optimal auction design. Mathematics of Operations Research, 6(1), 58–73. A
seminal paper, introduced revenue equivalence and optimal auctions.

 Riley, J., and Samuelson, W. (1981). Optimal auctions. The American Economic Review, 71(3),
381–392. A seminal paper; published concurrently with Myerson's paper cited above.

 Shoham, Yoav; Leyton-Brown, Kevin (2009). Multiagent Systems: Algorithmic, Game-Theoretic,


and Logical Foundations. New York: Cambridge University Press. ISBN 978-0-521-89943-7.
http://www.masfoundations.org. A recent textbook; see Chapter 11, which presents auction theory
from a computational perspective. Downloadable free online.

 Vickrey, W. (1961). Counterspeculation, auctions, and competitive sealed tenders. The Journal of
Finance, 16(1), 8–37. A seminal paper that introduced second price auctions and performed new
analysis of first price.

 Wilson, R. (1987a). Auction theory. In J. Eatwell, M. Milgate, P. Newman (Eds.), The New
Palgrave Dictionary of Economics, vol. I. London: Macmillan.

External links
 Auctions on GameTheory.net
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