E100: Microeconomics

Economics of Online and Digital Markets

Topic 1: Pricing behaviour in digital markets
Topic 2: Networks, platforms and multi-sided markets

Michaelmas Term 2022 E100: Microeconomics. Dr. Rupert Gatti 1

Topic 1: Pricing behaviour in digital markets
1.1 Pricing, auctions and optimal selling mechanisms
Revenue equivalence theorem, Revelation Principle
1.2 Posted prices and auctions on eBay
1.3 Position Auctions
Auctioning advertising space online

Michaelmas Term 2022 E100: Microeconomics. Dr. Rupert Gatti 2

 References
Chowdhury, S.M., D. Datta and S. Dhar (2019) “Auction Versus Posted Price Mechanism in Online
Sales: The Roles of Impatience and Dissuasion.” Studies in Microeconomics, 7(1), 75-88.
Edelman B., M. Ostrovsky, M. Schwartz (2007) “Internet Advertising and the Generalized Second-
Price Auction” American Economic Review, 97(1), 242-259
Einav, L., C. Farronato, J. Levin, and N. Sundaresan (2018) “Auctions versus Posted Prices in Online
Markets” Journal of Political Economy 126(1), 178-215.
Krishnan, V. (2002) Auction Theory, chs.3,5
Myerson, R. (1981) “Optimal Auction Design” Mathematics of Operations Research, 6.
Ostrovsky, M. and M. Schwarz (2016) “Reserve Prices in Internet Advertising Auctions: A Field
Experiment” Working paper https://web.stanford.edu/~ost/papers/rp.pdf
Varian, H. (2007) “Position Auctions” International Journal of Industrial Organisation, 25, 1163-
1178
Vickrey, W. (1962) “Auctions and Bidding Games” in Recent Advances in Game Theory, Princeton
Conference Series, 29.

Michaelmas Term 2022 E100: Microeconomics. Dr. Rupert Gatti 3

 1.1 Pricing, auctions and optimal selling
mechanisms

In this section we consider the advantages and disadvantages of

alternative selling mechanisms.

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Michaelmas Term 2022 E100: Microeconomics. Dr. Rupert Gatti 5
 Many offers

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 Many
purchase
mechanisms

Michaelmas Term 2022 E100: Microeconomics. Dr. Rupert Gatti 7

 This ad is delivered by
Google ads.

Advertising:
Direct &
Indirect
Michaelmas Term 2022 E100: Microeconomics. Dr. Rupert Gatti 8
The seller’s problem
I will initially model the seller’s problem like this:
The seller has a single item it wishes to sell.
There a N possible buyers.
The value (willingness to pay) of the item to buyer i is given by
𝑢𝑖 = 𝛾 where 𝛾 is an iid r.v. drawn from a distn F(.)
and is known only to buyer i.
These valuations are private values
that is, the value agent i places on the item is entirely
independent to the value agent j places on the item.
So, even if i learns j’s value – it will not change i’s value.
Question: How should the seller sell the item to maximise expected revenue?

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Posted-prices
It is common for sellers to post a “take-it-or-leave-it” price offer.
A retailer posting a price p, will sell the item providing somebody has a valuation greater than p.
So, E Revenue 𝑝 = 𝑝(1 − 𝐹(𝑝)𝑁 )
This is the probability
The sellers problem is to select the price that maximise expected revenue, so that at least one of the N
FOC: 𝑁
1 − 𝐹(𝑝) − 𝑝𝑁𝐹(𝑝) 𝑁−1 𝑓(𝑝) = 0 buyers has a valuation
greater than p.
If valuations drawn from a uniform distribution over [0,1] we have 𝐹 𝑝 = 𝑝, and 𝑓(𝑝) = 1
so the FOC becomes: 1 − (𝑁 + 1)𝑝𝑁 = 0
1
1 𝑁
𝑝 = 𝑁+1
1
𝑁 1 𝑁
and the maximised Expected Revenue = 𝑁+1 𝑁+1

Michaelmas Term 2022 E100: Microeconomics. Dr. Rupert Gatti 10

Is there a better way to sell the item?
An Auction? If so, what sort of auction?

Bargaining? If so, how should it be arranged?

Something else?

Of course First degree price discrimination is the best the seller can do.
But when valuations are private knowledge,
the same pricing mechanism must be offered to all customers.

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Auctions
There are four ‘standard’ auction mechanisms:
1. English (ascending) auctions (commonly used, eg Sotherby’s/farmers’ markets):
Auctioneer starts at a low price, and buyers make bids to raise the price – until no bidder
raises the price any further. Action is won by the highest bidder – at the price bid.
2. Second price sealed bid auctions (similar to eBay’s auction mechanism).
In this case buyers submit secret bids to the auctioneer, and the person submitting the
highest bid wins the auction, and pays the 2nd highest bid.
3. First price sealed bid auctions (used extensively in housing markets, procurement
contracts etc.):
Buyers submit bids. The buyer with the highest bid wins the auction, and pays their bid.
4. Dutch (descending) auctions – apparently used in Dutch flower markets.
Auctioneer starts at a high price, and slowly reduces the price until somebody agrees to
pay.

Question: Which is the best?

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1. English (ascending) auction
Buyers’ strategy:
The best strategy for any buyer (i) is to:
bid 𝑏𝑖 = 𝑏𝑗 + 𝜀 if 𝑏𝑗 is the highest bid and 𝑢𝑖 ≥ 𝑏𝑖
not bid otherwise.
If all buyers follow this strategy, then the winner will be the buyer with
the highest valuation, who will pay (approximately) the second highest
valuation.
So – if the N buyers are ordered by their valuation 𝑢1 ≥ 𝑢2 … ≥ 𝑢𝑁
Agent 1 will win the auction and pay a price 𝑝𝐸 = 𝑏1 = 𝑢2 .
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English (ascending) auctions 2
Expected revenue to seller
∞
E 𝑅 = ‫׬‬0 𝑏 [Prob that b is the winning bid] d𝑏
∞
= ‫׬‬0 𝑏 𝑁 1 − 𝐹 𝑏 𝑁 − 1 𝑓(𝑏)(𝐹(𝑏))𝑁−2 d𝑏

There are This is the But, given i This is the

N possible probability that wins the probability that
highest buyer i has auction, there buyer j has the
bidders valuation are (N-1) second highest
greater than b, possible second valuation, and
and wins the highest bidders that 𝑢 𝑗 = 𝑏
auction

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Example: Uniform Distribution
If the valuations are distributed uniformly on the unit interval [0,1]
In this case F(u)=u and f(u) = 1 for all 𝑢 ∈ 0,1 , so

1
E𝑅 = ‫׬‬0 𝑏 𝑁 1−𝑏 𝑁 − 1 1 (𝑏)𝑁−2 d𝑏
1
= 𝑁(𝑁 − 1) ‫׬‬0 (1 − 𝑏)𝑏 𝑁−1 d𝑏
1
𝑏𝑁 𝑏 𝑁+1
= 𝑁(𝑁 − 1) −
𝑁 𝑁+1 0
𝑁−1
= which converges to 1 as N gets large.
𝑁+1

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2. Second Price Sealed Bid Auction:
Buyers’ strategy: The best strategy for buyers is to bid their own valuation,
𝑏𝑖 = 𝑢𝑖 .
in this way they never pay more than they value the item – and never loose
out on winning the auction if they are able.
The outcome is that the bidder with the highest valuation will win the
auction and pay the second highest valuation.
𝑝𝑆𝑃 = 𝑏2 = 𝑢2

Which is precisely the same outcome as in the English auction.

So the expected revenue is the same as for the English auction.

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Vickrey Auction
An auction where the agents truthfully bid their own valuation; the winner is
the agent with the highest valuation; and the winner pays the ‘opportunity
cost’ incurred by others from the winner’s participation in the auction.

In our example, the agent with the second highest valuation does not win
the auction, and so looses out on gaining 𝑢2 .
The impact for all other agents is unchanged – as they would not have won
the auction in any case.
So the “opportunity cost” of agent 1’s participation for the other agents in
the auction is 𝑢2 , and this is the price agent 1 pays.
Thus the SPSB auction is a Vickrey Auction.

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First price Sealed Bid and Dutch auctions
Note: these two auctions are strategically equivalent.
The Dutch auction could run with buyers using the same prices as submitted to the
FPSB auction – and nothing would change.
Thus these two auctions are strategically equivalent and will give the same
expected revenue.

But clearly the bidding strategy adopted by buyers is a little more complicated than
in the English auction - as buyers will wish to ‘shave’ their bids to ensure they pay
less than their valuation if they win.
Buyers’ strategy:
in the uniform distribution example the (symmetric) equilibrium bidding strategy is
𝑁−1
𝑏𝑖 = 𝑢𝑖
𝑁

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Revenue Equivalence Theorem
Theorem 2.1 (RET): When buyers’ values are independently drawn from the
same (continuous and strictly increasing) distribution F(.),
and all bidders are risk neutral.
Then any auction in which
the bidder with the highest valuation always wins, and
a bidder with valuation zero will pay zero
yields the same expected revenue to the seller.

Proof:
Originally Vickrey 1962
See Kirshna Auction Theory ch.3.
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Implications of RET
No matter which auction mechanism is adopted – the expected revenue
earned by the seller is the same, namely (for the uniform distn case)
𝑁−1
E[𝑅] =
𝑁+1

And the same will be true for lots of other ‘bizarre’ auctions that satisfy RET
conditions – like, say,
“third-best auctions”; or
auctions were the winner pays the “average” bid; or
“all-pay” auctions where everybody has to pay their bid whether they
win or not (this is used to model lobbying activities sometimes)

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Auction vs Posted price
Seen that (with uniform distributions):
𝑁−1 ER
ER (auction) =
𝑁+1
1
𝑁 1 𝑁 Auction
ER (posted p)=
𝑁+1 𝑁+1
Posted price

So an auction will be preferred

when N ≥ 3

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Interpreting low N
N is the number of participants in the auction.
But this requires the buyers to be engaging simultaneously in the
purchasing process – both temporally and geographically.

If it is often difficult to coordinate buyers in this way

for retail stores buyers arriving independently, seeking different
items, and may not want to ‘hang around’ until a sufficiently
large number of other buyers arrive on the scene!
Thus - at point/time of sale N may often be one (or low)

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Auction with a reserve: Better than both
Implementing an auction with a ‘reserve price’ must do at least as well
as either the standard auction studied or a post-price.

By setting the reserve equal to the posted price, the revenue earned by
the seller can’t be lower with an auction – and may be higher – than
the posted price alone.

Similarly – the standard auction effectively has a reserve set equal to

zero. So if the optimal reserve is positive it is because it does better.

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Optimal Reserve Price in Second Price Auction
With a reserve price set at r
1
E 𝑅|𝑟 = 𝑟𝑁 1 − 𝐹 𝑟 𝐹(𝑟)𝑁−1 + ‫ 𝑁 𝑏 𝑟׬‬1 − 𝐹(𝑏) 𝑁 − 1 𝑓(𝑏) 𝐹(𝑏)𝑁−2 d𝑏

and for uniform distribution

1
E 𝑅|𝑟 = 𝑁 1 − 𝑟 𝑟 𝑁 + න 𝑁 1 − 𝑏 𝑁 − 1 𝑏 𝑁−1 d𝑏
𝑟
𝑁−1 𝑁−2𝑁𝑟+1
= + 𝑟𝑁
𝑁+1 𝑁+1
𝟏
Which is maximised when 𝒓 = .
𝟐

Note: the optimal reserve price is independent of N

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Optimal Revenue
𝟏
With 𝒓 = , and
𝟐 1
E 𝑅|𝑟 = 𝑁 1 − 𝑟 𝑟 𝑁 + න 𝑁 1 − 𝑏 𝑁 − 1 𝑏 𝑁−1 d𝑏
𝑟

1 𝑁−1 1 1 𝑁
have, E 𝑅|𝑟 = = + ( )
2 𝑁+1 𝑁+1 2

Note that, when N=1 this gives the same solution as a posted-price,
and as N becomes large, the expected revenue from the SP auction
approaches the optimal.

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But could we do better still?
Could we design a different mechanism to ‘sell’ an object which could
achieve a higher revenue still.

Let us define a selling mechanism to be:

a set of signals/bids for each buyer
a rule for allocating the good, based on the bids observed
and a payment rule, also based on the bids observed

Question: what is the selling mechanism that maximises expected revenue?

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Optimal mechanism
Define an optimal mechanism to be one that
maximises expected revenue,
is incentive compatible (so best to declare your true valuation if
everybody else is truthful)
and individually rational (so not participating is always an
available option)

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Revelation Principle
Given a mechanism, and an equilibrium outcome for that mechanism,
there exists a Direct Mechanism in which:
it is an equilibrium for all agents to truthfully reveal their
valuation, and
the outcome is the same as in the equilibrium of the original
mechanism.

Thus, in looking for an optimal mechanism we need only consider

Direct Mechanisms.

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Optimal Mechanism
Theorem 2.2: Myerson (1981)
Whenever the buyers’ valuations are symmetric
(drawn from the same distribution F(.) )
and regular
(the hazard rate function for the distribution (f(x)/(1-F(x)) ) is increasing
in x)

Then a second price auction with an optimal reserve is an optimal

mechanism.

So – this is the best we can do!

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Efficiency
Although it maximises the sellers expected revenue
a second priced auction with a reserve is not efficient,

it is possible that the item remains unsold – even though somebody

would have been prepared to pay a positive price for it.

If we care about efficiency, then the RET holds – and we know that
a Vickrey Auction (second priced auction without a reserve) is as good
as we can do.
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Why are posted prices so prevalent then?
Significant transaction costs associated with auctions, for both buyers and sellers:
Sellers:
need to coordinate buyers to engage simultaneously
requires communication between all buyers – allowing dynamic submission of bids, and
bid processing
more costly to implement
competition between sellers for sale of identical product

Buyers:
need to wait for auction to complete (impatience)
may require more direct engagement in the bidding process
outcome remains uncertain until the end
may have a desirable alternative option available (before auction completes)

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Online markets
But many of these problems may be reduced with digital technology in
an online market
easier to coordinate multiple buyers in time/(virtual)space
submit programmatic strategies
easier to administer interaction between buyers and bid
processing

So it is maybe not surprising to find auctions having more of a presence

in online markets.

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 1.2 Auction versus Posted Prices in Online Markets
Einav et al. Journal of Political Economy 2018
Chowdhury et al. Studies in Microeconomics 2019

Auction share on eBay

over time

Note: The
fixed auction
end time eBay introduced
means eBay is “good till cancelled”
posted price listing
NOT a pure
second-price
auction.
Source: Einav et al. 2018
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 Auction versus Posted Prices 2

Source: Einav et al. 2018

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 Auction versus Posted Prices 3

Source: Einav et al. 2018

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Stylised Facts:
Proportion of auction listings on eBay has consistently fallen since 2003
Posted prices more commonly used
for “new” items
when multiple listings by seller
Sale rate higher for auctions – but all sales rates falling over time
(and fewer bidders)
Sale price lower for auctions – with difference growing over time
Of course expected revenue is the interaction of these two, but both falling
means auctions less attractive to sellers over time.
Consumers dislike waiting for auctions to complete (impatient), and become
disillusioned by past failure to win item (dissuasion).

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Possible explanations:
Product composition:
over time eBay more new vs second hand items sold
Seller composition:
Increasingly traditional retail store selling on eBay, without
expertise/experience in auctions – or not wanting to upset/cannabilise
their existing customers.
Consumer composition/behaviour:
Consumers have increasing alternatives for online shopping – so demand
has fallen generally (which disproportionately affects auctions)
Consumer preference for immediate purchase/delivery has increased –
so disutility of participation in auction has grown.

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Possible explanations: Tested by Einev et al.
Product composition:
over time eBay more new vs second hand items sold
Seller composition:
Increasingly traditional retail store selling on eBay, without
expertise/experience in auctions – or not wanting to upset/cannabilise
their existing customers.
Consumer composition/behaviour:
Consumers have increasing alternatives for online shopping – so demand
has fallen generally (which disproportionately affects auctions)
Consumer preference for immediate purchase/delivery has increased –
so disutility of participation in auction has grown.

Michaelmas Term 2022 E100: Microeconomics. Dr. Rupert Gatti 39

Other stylised facts
Auctions attract a higher proportion of “professional” buyers
In auctions – professional buyers obtain bigger discounts than inexperienced
buyers

Many sellers list the same item as both auction and “buy it now” – often
simultaneously.

Possible explanations (not tested)

Experimentation
Market segmentation – exploiting differences between impatient
buyers and (more price sensitive) patient buyers.

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