Third

Price Auction
MICROECONOMICS II, PART II P ROF. EMRE OZDENOREN

3rd Price Auction

First, let us find the distribution of the 3rd highest bid, given that player 𝑖 wins the bid. Since we assume
that players with higher values bid higher, the fact that someone’s bid is higher than the other player’s
bid is the same as saying that her value is higher (in the equilibrium).

Consider a player with value 𝑥. Then this player wins if and only if the maximum of the values of the
other 𝑁 − 1 players is not greater than 𝑥. The amount she pays in this situation will be the bid of the
person with the 3rd highest value (or 2nd highest out of the other 𝑁 − 1 people). The distribution of
this value (conditional on the fact that the first player wins the auction) is:

ℙ2𝑌 (4) ≤ 𝑦, 𝑌 (7) ≤ 𝑥8

𝐹' ()) |' (,) -. (𝑦) = ℙ2𝑌 (4) ≤ 𝑦6𝑌 (7) ≤ 𝑥8 =
ℙ(𝑌 (7) ≤ 𝑥)
ℙ(∀𝑖 𝑌< ≤ 𝑦) + ∑CD7
<E7 ℙ(𝑦 < 𝑌< ≤ 𝑥)ℙ2∀𝑗 ≠ 𝑖 𝑌B ≤ 𝑦8
= =𝐴
ℙ(𝑌7 ≤ 𝑥)ℙ(𝑌4 ≤ 𝑥) … ℙ(𝑌CD7 ≤ 𝑥)

The components of this expression are equal to:

ℙ(𝑌7 ≤ 𝑥)ℙ(𝑌4 ≤ 𝑥) … ℙ(𝑌CD7 ≤ 𝑥) = 𝐹 CD7 (𝑥)

ℙ(∀𝑖 𝑌< ≤ 𝑦) = ℙ(𝑌7 ≤ 𝑦)ℙ(𝑌4 ≤ 𝑦) … ℙ(𝑌CD7 ≤ 𝑦) = 𝐹 CD7 (𝑦)

CD7

H ℙ(𝑦 < 𝑌< ≤ 𝑥)ℙ2∀𝑗 ≠ 𝑖 𝑌B ≤ 𝑦8 = (𝑁 − 1)ℙ(𝑦 < 𝑌7 ≤ 𝑥)ℙ2∀𝑗 ≥ 2 𝑌B ≤ 𝑦8

<E7
= (𝑁 − 1)2𝐹(𝑥) − 𝐹 (𝑦)8𝐹 CD4 (𝑦)

Finally,

(𝑁 − 1)𝐹 CD4 (𝑦)𝐹(𝑥) − (𝑁 − 2)𝐹 CD7 (𝑦)

𝐴=
𝐹CD7 (𝑥)

We can calculate the density of this conditional distribution:

(𝑁 − 1)(𝑁 − 2)𝐹 CDM (𝑦)

𝑓' ()) |' (,) -. (𝑦) = 𝐹′' ()) |' (,) -. (𝑦) = 2𝐹(𝑥) − 𝐹(𝑦)8𝑓(𝑦)
𝐹CD7 (𝑥)

This distribution is useful to calculate the optimal strategy of the players in the 3rd price auction. To
find the optimal strategy in this auction I will use the revenue equivalence principle: I will calculate
the expectation of the payment of player 𝑖 given the equilibrium bidding strategy 𝛽OOO (𝑣), and then
equate it to the expected payment in the second price auction (since in all auction the payment should
be the same).
.
𝑚 OOO (𝑥) = ℙ(𝑝𝑙𝑎𝑦𝑒𝑟 𝑖 𝑤𝑖𝑡ℎ 𝑣𝑎𝑙𝑢𝑒 𝑥 𝑤𝑖𝑛𝑠) ] 𝛽OOO (𝑦)𝑓' ()) |' (,) -. (𝑦) 𝑑𝑦 = 𝑚 OO (𝑥)
^

1
Here 𝑚 OO (𝑥) and 𝑚 OOO (𝑥) are the expected payments in the second and the third price auctinos.
.
𝑚 OO (𝑥) = ] 𝑦𝑔(𝑦)𝑑𝑦
^

𝑔(𝑦) is the density function of the distribution of the second highest value. So, 𝐺 (𝑦) = 𝐹 CD7 (𝑦) and
𝑔(𝑦) = 𝐺 b (𝑦) = (𝑁 − 1)𝑓 (𝑦)𝐹 CD4 (𝑦), so
. .
(𝑁 − 1) ] 𝑦𝑓(𝑦)𝐹 CD4 (𝑦)𝑑𝑦 = ℙ(𝑝𝑙𝑎𝑦𝑒𝑟 𝑖 𝑤𝑖𝑡ℎ 𝑣𝑎𝑙𝑢𝑒 𝑥 𝑤𝑖𝑛𝑠) ] 𝛽OOO (𝑦)𝑓' ()) |' (,) -. (𝑦) 𝑑𝑦
^ ^
.
= (𝑁 − 1)(𝑁 − 2) ] 𝛽OOO (𝑦)𝐹 CDM (𝑦)2𝐹(𝑥) − 𝐹 (𝑦)8𝑓(𝑦)𝑑𝑦
^

Differentiate both parts with respect to 𝑥.1

.
𝑥𝑓 (𝑥)𝐹 CD4 (𝑥) = (𝑁 − 2) c𝐹 CD4 (𝑥)𝛽OOO (𝑥)𝑓(𝑦) + ] 𝛽OOO (𝑦)𝐹 CDM (𝑦)𝑓(𝑥)𝑓(𝑦)𝑑𝑦
^
.
− 𝐹 CD4 (𝑥)𝛽OOO (𝑥)𝑓 (𝑦)d = (𝑁 − 2)𝑓(𝑥) ] 𝛽OOO (𝑦)𝐹 CDM (𝑦)𝑓(𝑦)𝑑𝑦
^

Divide both parts by 𝑓 (𝑥) and differentiate again:

(𝑁 − 2)𝑥𝐹 CDM (𝑥)𝑓(𝑥) + 𝐹 CD4 (𝑥) = (𝑁 − 2)𝐹 CDM (𝑥)𝛽OOO (𝑥)𝑓 (𝑥)

Hence,

𝐹 (𝑥)
𝛽OOO (𝑥) = 𝑥 +
(𝑁 − 2)𝑓(𝑥)

It is easy to see that the equilibrium bid is above one’s valuation. This is not surprising, because if the
agents played the same strategy as in the second price auction (which is bidding their own valuations),
they would on average pay less, and as we know, it should not be the case according to the revenue
equivalence principle.

e g(.) g(.) ij(.,k)

1
Remember Leibniz’s interal rule: e. ∫h(.) 𝑓(𝑥, 𝑦)𝑑𝑦 = ∫h(.) i.
𝑑𝑦 + 𝑓(𝑏(𝑥), 𝑥)𝑏 b (𝑥) − 𝑓(𝑎(𝑥), 𝑥)𝑎b (𝑥).