Auctions

Auction theory is an application of Bayesian

games. Many economic transactions are
conducted via auctions: from the sale of
Treasury Bills, to oil drilling rights, to
day-today items on Ebay.

Auctions have a variety of formats. Gen-

erally, we will describe an auction as a
game where:
1. Buyers ‘bid’ for an object owned by a
seller.
2. The object is allocated to one of the
buyers.
3. Buyers make payments to the seller.
In some auctions, for instance procure-
ment auctions, the bidders are the sell-
ers. For simplicity, we will assume that
the bidders are always buyers. The for-
mal analysis is substantially identical to
the case where the bidders are the sell-
ers.

Four types of formats have extensively

been studied.
1
Ascending-bid Auction (English auction):
In this auction the price is progressively
raised until only one bidder is willing to
obtain the object at that price. This auc-
tion can have a number of sub-formats
where the auctioneer announces the prices
or the bidders call out the prices.

Descending-bid Auction (Dutch auction):

In this auction the price is progressively
lowered until one of the bidders accepts
the price.

First-price (sealed-bid) Auction: Each

bidder submits a bid and does not see the
bids submitted by the other bidders. The
object is allocated to the buyer who sub-
mits the highest bid at a price equal to
the bid.

Second-price (sealed-bid) Auction: Each

bidder submits a bid and does not see the
bids submitted by the other bidders. The
object is allocated to the buyer who sub-
mits the highest bid at a price equal to
the second highest bid.

2
To clarify the difference between first and
second-price auctions, suppose that we
have three bidders, 1, 2, and 3, bidder
1 submits £100, bidder 2 £50, and bidder
3 £25.
• In a first-price auction bidder 1 gets
the object and pays £100.
• In a second-price auction bidder 1 also
gets the object but pays £50.
Let’s now consider a simple model for
sealed-bid auctions. We have
• a seller who owns an object that for
simplicity is worth nothing to her and
hopes to raises money by selling it at
auction;
• two potential buyers, bidder 1 and bid-
der 2. The monetary valuations of the
objects for these bidders are v1 and v2,
respectively.
If bidder i wins the object and pays x, his
payoff is
vi − x.
The bidder who does not win the object
pays zero. The payoff of the seller is x.

3
The valuations of the bidders are private
information:
• each bidder knows only his valuation
and the seller knows neither valuation.
For instance, the object is an ancient arte-
fact for which each buyer has a personal
valuation that is only known to him.

We model this auction as a Bayesian game:

• Nature chooses the valuations (the types
of the players) from a probability dis-
tribution;
• Each bidder learns his own valuation.
The probability distribution used by
Nature is known to the bidders and
the seller.
In Bayesian games, players choose actions
that are contingent on their types: the
strategy of each bidder i is a bidding
function
bi(vi)
that assigns a bid to each possible valua-
tion vi of bidder i.

4
Let’s suppose that the valuations of the
bidders are chosen independently and uni-
formly between the lowest possible value
v and the highest possible value v. Then,
the probability that valuation vi of bidder
i is less than y in [v, v] is
y−v
v−v

Intuitively, the probability that the valua-

tion is smaller than some value y is the
ratio between the distance y − v and the
maximum range (the support) v − v.

Let’s use the example in the textbook and

suppose that the lowest possible value is
v = 0 and the highest possible value is
v = 900.

5
Let’s first consider a second-price auc-
tion. We will now show a classic result:
in a Bayesian Nash equilibrium each bid-
der bids his own valuation, that is,

bi(vi) = vi.
So let’s suppose that Nature has chosen
the valuation v1 for bidder 1. We will first
see that any bid x of bidder 1 such that

x > v1
cannot achieve a higher payoff than bid-
ding v1, whatever the bid b2 of bidder 2
will turn out to be.
1. If b2 > x > v1, bidding x or v1 makes
no difference for bidder 1 since bidder
2 wins the object.
2. If x > b2 > v1, by bidding x bidder 1
wins the object and pays b2, the sec-
ond highest bid, thus getting payoff
v1 − b2 < 0. By bidding v1, the payoff
is equal to zero since bidder 2 wins the
object: bidder 1 is better off bidding
v1.
3. If x > v1 > b2, regardless of whether
bidder 1 bids x or v1, he wins the ob-
ject and pays b2 thus getting a pos-
itive payoff v1 − b2: bidding x or v1
makes no difference. 6
We have so far considered only ‘strict’ in-
equalities. What if the bids are tied, and
thus the second highest bid is the same
as the highest bid? Whatever the ‘tie-
breaking’ rule for allocating the object, by
bidding x > v1 bidder 1 cannot be better
off:
• If x = b2 > v1 and bidder 1 ends up
winning the object by bidding x, he
pays pays b2 and gets a payoff v1 −b2 <
0. By bidding v1 the payoff is equal
to zero since bidder 2 wins the object.
• If x > b2 = v1, by bidding x bidder
1 wins the object and gets a payoff
v1 − b2 = 0. By bidding v1 the payoff
is also equal to zero whether or not
the object is won by bidder 1 since
v1 = b2.
The case of a bid x < v1 is analogous and
is left as an exercise.

Note that the above argument works for

any probability distributions of the valua-
tions.
• In a second-price auction, no matter
how the valuations are distributed the
players bidding their own valuations is
a Bayesian Nash equilibrium.
7
The expected revenue of the seller in this
auction is equal to the expected second-
highest bid since this is the amount the
highest bidder pays. The following calcu-
lation of the seller’s expected revenue is
optional and not required for this course.

In our example, the probability that valu-

ation vi of bidder i is smaller than a value
y in [0, 900] is
y
900
and that vi is larger than a value y in
[0, 900] is
y 900 − y
1− = .
900 900

Because the distribution is uniform, the

expected value of vi is at the centre of
the interval [0, 900], that is,

900
1
E(vi) = · vidvi = 450
900
0
8
Suppose now we have additional informa-
tion. For instance, we know that vi ≤ x
for some x in [0, 900]. What is the ex-
pected value of vi conditional on being
smaller than x? It is at the centre of the
interval [0, x]. Hence,
x
E(vi | vi ≤ x) = .
2

Suppose that we are instead told that

vi ≥ x where x is in [0, 900]. The ex-
pected value of vi conditional on being
greater than x is at the centre of the in-
terval [x, 900]. Hence,
900 + x
E(vi | vi ≥ x) = .
2

To calculate the expected revenue of the

seller, we first fix the valuation of bidder
1 at some value v1. That is, suppose we
know the valuation of bidder 1. What is
the seller’s expected revenue?
9
 • When v2 ≤ v1, which has probability
v1
(y = v1 in the previous formula),
900
bidder 1 wins the auction and pays the
bid of player 2, which is v2 (ties do
not matter). Hence, the expected bid
of bidder 2 is (x = v1 in the previous
formula)
v
E(v2 | v2 ≤ v1) = 1 .
2
• When v2 > v1,which has probability
900 − v1
, bidder 2 wins the auction
900
and pays v1.
Hence, if we know that the valuation of
the bidder is v1, the expected revenue of
the seller is
v1 v1 900 − v1
· + · v1.
900 2 900

But we do not know v1. We know that

it has a uniform distribution on [0, 900].
The expected revenue of the seller is then
the expected value of the above expres-
sion:

900
1 v v 900 − v1
·( 1 · 1 + ·v1)dv1 = 300.
900 900 2 900
0
10
Let’s now consider a first-price auction:
the highest bidder wins the object and
pays his bid. For instance, if bidder 1 bids
100 and and bidder 2 bids 150, bidder 2
wins and pays 150.

The bidding functions in a Bayesian Nash

equilibrium are somewhat more compli-
cated than in the second-price auction. In
our example, however, they have a simple
form.

First note that if the bidders bid their

valuation, as in the second-price auction,
their payoff is equal to zero since if they
win the object they pay their valuation.
Hence, it seems reasonable to suppose
that they will bid less than their valuation
to earn a positive payoff.

Let’s conjecture that the bids are propor-

tional to the valuations, that is,
bi(vi) = avi, a < 1.

The bidders will then bid less than their

valuation and earn a positive payoff. Can
we find a value of the parameter a for
which such bids are a Bayesian Nash equi-
librium?
11
Let’s suppose that bidder 2’s bidding func-
tion is, as conjectured,
b2(v2) = av2,
and find the best response of bidder 1. If
bidder 1 bids b1, he wins when
b
b1 > av2 ⇒ v2 < 1 .
a
Since v2 is uniformly distributed on [0, 900],
the probability that player 1 wins the ob-
ject when bidding b1 is
b1
a = b1 .
900 900a

Then, bidder 1 expected payoff when his

valuation is v1 is
b1
(v1 − b1) · .
900a

If we maximise the above payoff we have

the first order condition
v1 − 2b1 v1
= 0 ⇒ b1 = .
900a 2
12
We conclude that bidder 1’s strategy
v1
b1(v1) =
2
is a best response for any value of the pa-
rameter a. This strategy does have the
form that we conjectured: the bid is pro-
portional to the valuation (a = 1/2). By
symmetry, we conclude that
v
b2(v2) = 2
2
is a best response to the above strategy
for bidder 1. Hence,
v1 v2
b1(v1) = b2(v2) =
2 2
is a Bayesian Nash equilibrium. In con-
trast to the second-price auction, where
the bidders bid their valuation, in the first-
price auction the bidders bid half their val-
uation.
• In a first-price auction the equilibrium
bidding functions depend on the dis-
tribution of valuations. In our exam-
ple, they have a simple form because
we have assumed that the valuation
are uniformly and independently dis-
tributed. With a different distribu-
tion the equilibrium bids will be differ-
ent and not necessarily proportional
to the valuations.
13
 What is the seller’s expected revenue in
this first-price auction? This calculation
is again optional. As before, we first find
the revenue fixing the valuation of bidder
1 at some value v1:
• When v2 ≤ v1, which has probability
v1
, bidder 1 wins the auction and
900
v
pays his bid 1 (ties again do not mat-
2
ter).
• When v2 > v1,which has probability
900 − v1
, bidder 2 wins the auction.
900
v
Since bidder 2 bids 2 , his expected
2
bid conditional on v2 > v1 is
1 1 900 + v1
· E(v2 | v2 > v1) = · .
2 2 2
Hence, when the valuation of bidder 1 is
v1, the expected revenue of the seller is
v1 v1 900 − v1 1 900 + v1
· + · · .
900 2 900 2 2
Since v1 has a uniform distribution on
[0, 900], the expected revenue is

900
1 v v 900 − v1 900 + v1
·( 1 · 1 + · )dv1 = 300.
900 900 2 900 4
0

14
Remarkably, the revenues of the first-price
and second-price auctions are identical.
This is a celebrated result known as the
Revenue Equivalence Theorem:
When the valuations of the bidders
are identically and independently dis-
tributed, first-price and second-price
auctions (and more) yield the same
revenue.
How about the ascending auction? It is
not difficult to see that an ascending auc-
tion is essentially equivalent to a second-
price auction.

Suppose that for instance the valuation

of bidder 1 is 250 and the valuation of
bidder 2 is 100.
• As the auctioneer raises the price in-
crementally, at what price will bidder
1 become the sole active bidder and
thus acquire the object?
• When the price is 100 (or just above
or just below, depending on the size
of the increments) since bidder 2 will
no longer be interested.
• In essence, the bid at which the object
is acquired it is equal to the second
highest valuation as in the second-
price auction. 15
It can also be shown that the descend-
ing auction is equivalent to a first-price
auction. Hence, the Revenue Equivalence
Theorem includes the ascending and de-
scending auctions.

Note that, under the assumptions of the

Revenue Equivalence Theorem, all these
auctions are also efficient:
• since the object is awarded to the bid-
der with the highest valuation, there
are no additional gains for trade among
the bidders after the auction.
It would be tempting to conclude that the
design of auctions is irrelevant since they
all seem to achieve the same revenues and
outcomes. However, the assumption that
valuations are independent and identically
distributed is a strong one.
• The Revenue Equivalence Theorem is
useful only as a benchmark and not
for realistic applications.
But, as any important benchmark, it sug-
gests interesting directions of study for
which the issue of auction design may be
of relevance. Let’s consider as an exam-
ple the case of common values which in-
validates the assumption of independent
valuations.
16
Suppose for instance that we are auction-
ing the drilling rights for an oil field.
• The value is the same for all bidders
and is the (common) value of the amount
of oil that is contained in this field.
However, suppose that bidders are uncer-
tain about the amount of oil in the field
but have private information: they have
each conducted their own geological sur-
vey. Hence, they each have their own es-
timate of the ‘common’ value and these
estimates could be different.

Government bonds is another example.

The future value will be the same for ev-
ery bidder but bidders could have het-
erogeneous information and thus different
expectations about the value.

One aspect is very much relevant to both

cases: if a bidder was able to acquire the
information that the other bidders have,
he/she could form a better estimate of
the value of the object.

17
This observation has some important con-
sequences on bidding behaviour. If a bid-
der wins the auction, he must lower his
ex-ante expected valuation of the object:
• a bidder wins when the other bidders
value the object less according to their
own information;
• thus winning the auction reveals ‘neg-
ative’ information to the winner who
should lower his valuation.
This phenomenon is called the winner’s
curse. For instance, winning the drilling
rights for an oil field reveals that the other
bidders’ geological surveys probably found
less oil than winner’s survey.

Under common values, the Revenue Equiv-

alence Theorem fails: typically, ascend-
ing auctions generate higher revenue than
second-price auctions, which generate higher
revenue than first-price auctions.

Hence, with common values, the choice of

auction is crucial for the seller’s revenue.

18
Auction design has been a widely studied
topic, theoretically and experimentally. Spec-
trum auctions, where governments sell the
rights to transmit telecommunication sig-
nals have received a great deal of atten-
tion from auction designers, with mixed
success. Two objectives are prominent in
auction design:
• Efficiency: assigning the object to the
bidder who values it most.
• Revenue generation: maximising the
seller’s revenue.
In addition to the bidding behaviour in dif-
ferent auctions, two considerations, which
we have not addressed directly, play a role
in auction design:
• Encouraging the entry of bidders.
• Preventing collusion among bidders.
Both considerations are central for effi-
ciency and revenue generation. We will
see the effects of an increase in the num-
ber of bidders in an exercise. Collusion
can be a problem when many items are
auctioned simultaneously with a small num-
ber of bidders: bidders can ‘divide up the
items’ cooperatively and bid less aggres-
sively on each item. Ascending auctions
where the bidding process is observed are
especially vulnerable since early ‘visible’
bids can be used to communicate the bid-
ders’ intentions.
19
Many auctions have a reserve price, that
is a minimum bid and payment necessary
to acquire the object. Of course, when
the object has value for the seller it is
reasonable to have a reserve price that is
at least as high as her valuation.
• Can a reserve price that is above the
seller’s valuation increase the revenue
of the seller?
Let’s return to our example where the
seller’s valuation for the object is equal
to zero and two bidders have indepen-
dent valuations uniformly distributed on
[0, 900].
• Would this seller generate a higher ex-
pected revenue by setting a positive
reserve price?
Recall that the seller’s expected revenue
for all the auctions that we considered is
equal to 300.

Suppose that the seller sets a reserve price

equal to 450 in a first-price auction. Of
course, the equilibrium bids will change.
However, we do not need to know what
they are to show that the seller’s revenue
will exceed 300.
20
If one of the bidders has a valuation larger
than 450, he will bid at least 450 since
this is the minimum bid. What is the
probability that at least one bidder has
a valuation higher that 450? Recall that
the probability that one bidder has a val-
uation vi lower than for 450 is
vi 450 1
= = .
900 900 2

Since the valuations are independent, the

probability that both bidders have a valu-
1
ation lower than for 450 is . Then, with
4
3
probability equal to at least one bidder
4
has a valuation higher than 450. This im-
3
plies that, with probability equal to the
4
revenue of the seller will be at least 450,
that is, her expected revenue will be at
least
3
· 450 > 300.
4
The seller will achieve a higher expected
revenue by setting a positive reserve price.

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