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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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Auction theory - Wikipedia, the free encyclopedia Page 2 of 5

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.

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

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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Auction theory - Wikipedia, the free encyclopedia Page 4 of 5

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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Auction theory - Wikipedia, the free encyclopedia Page 5 of 5

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.

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

Retrieved from "http://en.wikipedia.org/wiki/Auction_theory"

Categories: Auction theory | Game theory

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may apply. See Terms of Use for details.

Wikipedia® is a registered trademark of the Wikimedia Foundation, Inc., a non-profit organization.

http://en.wikipedia.org/wiki/Auction_theory 3/22/2010

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