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ARE THE VICKREY AUCTION AND THE BDM MECHANISM REALLY INCENTIVE COMPATIBLE? EMPIRICAL RESULTS AND OPTIMAL BIDDING STRATEGIES IN CASES OF UNCERTAIN WILLINGNESS-TO-PAY**

ABSTRACT

Willingness-to-pay (WTP) data elicited with the help of incentive compatible methods like the Vickrey auction and the BDM mechanism promise higher validity than stated preferences data and provide more information content than do revealed-preferences data. However, research shows that subjects in a Vickrey auction do not always follow the dominant strategy of bidding their WTP, but frequently bid too high or too low. Although this phenomenon is usually attributed to irrational behavior, that need not be the only explanation. In marketing research applications, subjects are typically asked their WTP for a new product, and it appears that most subjects are uncertain about their exact WTP. We present a modied bidding model to explain that in this case, it is optimal for risk-averse but rational bidders to underestimate, rather than to overestimate, their WTP. The model is supported by preliminary experimental data. JEL-Classication: D81, M31. Keywords: BDM-mechanism; Discriminal Dispersion; Incentive Compatibility; Vickrey Auction; Willingness-to-pay.

1 INTRODUCTION With the advent of strategies like price bundling, two-part-tariffs, and internet pricing, the whole field of pricing has been experiencing a renaissance in both practical applications and in theory. This development has led to the increased need for valid methods to measure the willingness-to-pay (WTP) of every single customer for a given product (Cameron and James (1987, 389)). However, eliciting valid WTP data is a problem that has not yet been adequately solved. Traditionally, marketing research has used two elicitation methods: The analysis of revealed-preference data and stated-preference data. Revealed-preference data normally do not allow the elicitation of exact WTP

* Klaus Peter Kaas, Professor of Marketing, Heidrun Ruprecht, Research Assistant, Professur fr Betriebswirtschaftslehre, insb. Marketing I, Goethe-Universitt Frankfurt am Main, Mertonstr. 17-25, 60054 Frankfurt, Germany, Tel.: (+49)-69-798-23925, Fax: (+49)-69-798-23402, Email: kaas@marketing.uni-frankfurt.de. ** We would like to thank the German Research Foundation (DFG) for the financial support (KA 397/ 6-1) for this research project.

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of individual customers, but are limited to aggregate information such as price-response functions (Ben-Akiva et al. (1994, 344)). To the contrary, stated-preference data yield individual WTP data. However, the validity of such data is generally assumed to be low, because subjects give hypothetical answers to hypothetical questions (Carson, Groves, and Machina (2000, 41)). Since the beginning of the 1990s an additional class of methods has received increasing attention. These are the so-called incentive-compatible methods, which have been widely discussed in experimental economics and which may be able to overcome the limits of the traditional marketing research methods (Hoffman et al. (1993)). The incentive-compatible methods include the Vickrey auction (Vickrey (1961)) and the BDM mechanism (after Becker, DeGroot, and Marschak (1964)). The validity of the WTP data obtained with these methods should be high, due to the incentives. The incentives work as subjects are put in a real purchase situation: they are asked to submit a binding purchase offer for the product in question, without being able to influence the resulting price with their offer. Therefore, it is optimal for rational subjects to reveal their exact WTP (Shogren et al. (2001a); Wertenbroch and Skiera (2002, 230)). Although incentive compatibility has been proven in theory, doubts remain as to the behavioral properties of both methods (Kagel (1995); Harstad (2000)). If the methods were also behaviorally incentive compatible, no overbidding or underbidding should be observed, and the resulting WTP distributions should be the same for both methods. However, this is not always the case, as studies from experimental economics and marketing research show. More research is needed to determine whether the incentive compatible methods keep their theoretical promise in empirical applications. If we were to find systematic deviations from the theoretical predictions, it would be helpful to know their direction and scope. The aim of this paper is to contribute both empirically and theoretically to this ongoing research. To accomplish our goal, we present empirical results from an experimental study that compares the WTP for a new chocolate brand, which we measure by incentivecompatible methods and stated preferences. In addition, we obtain indicators for overbidding and underbidding from a questionnaire. The findings are striking: the bids in the incentive-compatible methods are not only below the WTP measured by the stated-preference data, but also below the true WTP. This tendency towards underbidding is slightly stronger in the Vickrey auction than in the BDM mechanism. The theoretical contribution of our paper comprises a modified bidding model. The main idea of the model is a discriminal dispersion of WTP, which can be thought of as a perception or measurement error of the subjects when they try to find their true WTP. The model shows that rational, risk-averse bidders who maximize their utility according to expected utility theory (Von Neumann and Morgenstern (1947)) would rather underestimate their WTP than overestimate it.

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The paper continues as follows. Section 2 outlines the Vickrey auction and the BDM mechanism. We discuss the empirical results from the experimental economics and marketing research literature, focusing on the findings on overbidding and underbidding. Section 3 presents our design and interpretation of a new experimental study. In Section 4 we develop the model of bidding under discriminal dispersion. We demonstrate that the underbidding found in the experiment can be explained by this model. In Section 5 we conclude with implications for the practical measurement of WTP and further theoretical research. 2 PRIOR RESEARCH ON INCENTIVE - COMPATIBLE METHODS

2.1 VICKREY AUCTION AND BDM MECHANISM The Vickrey auction, developed by William Vickrey (1961), is also known as a secondprice sealed-bid auction. As the name implies, the bids are submitted using a sealed bid procedure in which the individual bids cannot be observed by rival bidders, and the highest bidder wins the auction at the second-highest bid price. The incentive compatibility is achieved through the fact that the winners bid cannot influence the price she pays (McAfee and McMillan (1987, 708)). The dominant strategy for all bidders is to bid their exact WTP, independent of the number of bidders and their behavior in the auction (Vickrey (1961, 22)). The BDM mechanism works in much the same way as the Vickrey auction, but differs in the rule determining the price a bidder has to pay (Davis and Holt (1993, 461)). The price is not the result of competition between the bidders in an auction, but is determined randomly, e.g., by a draw from a uniform distribution. Every subject whose bid equals or exceeds the random price buys the product at this random price; all other subjects are not allowed to buy the product (Wertenbroch and Skiera (2002, 230)). Both the Vickrey auction and the BDM mechanism are theoretically incentive compatible, as it is optimal for a rational bidder to bid her exact WTP (McAfee and McMillan (1987, 712)). But are they also behaviorally incentive compatible, i.e., do subjects behave according to the theoretical predictions and actually bid their exact WTP (Hofmann et al. (1993, 322); Rutstrm (1998, 428))? Behavioral incentive compatibility is obviously difficult to test, since the subjects true WTP cannot be observed. To overcome this difficulty, we can either control the true WTP by inducing values for imaginary products (Smith (1976)), or we can determine and validate the WTP for real products with the help of indicators obtained through a questionnaire and through method comparisons. 2.2 TESTS OF INCENTIVE COMPATIBILITY IN INDUCED -VALUES EXPERIMENTS Because it allows the bidding strategy to be isolated, the experimental economics literature has applied the induced-values design mainly to test the behavioral properties of the Vickrey auction (e.g., Coppinger, Smith, and Titus (1980)). From the available studies with

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induced values, we can draw the following conclusion: the dominant strategy seems not to be intuitive in the Vickrey auction, subjects react with underbidding or overbidding. Studies by Coppinger, Smith, and Titus (1980), Cox, Roberson, and Smith (1982) and Harstad (2000) show an overall tendency towards underbidding. Underbidding may stem from the illusion that a lower bid may lower the price without lowering the chances of winning. Other studies find evidence of moderate overbidding in Vickrey auctions (Kagel, Harstad, and Levin (1987), Kagel and Levin (1993)). Kagel and Levin (1993) illustrate the appeal of overbidding as follows: () the idea that bidding modestly in excess of x only increases the chances of winning the auction when you do not want to win is far from obvious under the sealed bid procedure (p. 1286). Studies by Gth, Schmittberger, and Schwarze (1983) and Sonnegrd (1996) report strong, frequent underbidding and some moderate overbidding. Overall, it appears that subjects react heterogeneously, but mostly with underbidding, such that the WTP distribution obtained by a Vickrey auction should on average produce values too low. 2.3 TESTS OF INCENTIVE COMPATIBILITY FOR REAL PRODUCTS How can we evaluate the behavioral incentive compatibility of the Vickrey auction and BDM mechanism in the case of real products? Since the true WTP remain unknown, tests must rely on indicators of bidding strategy and method comparisons. These are the approaches used in marketing research applications (Skiera and Revenstorff (1999)). Studies involving method comparisons between incentive-compatible and stated-preferences methods overwhelmingly conclude that stated WTP are higher1. This result is generally attributed to a hypothetical bias of stated preferences. Validity tests also favor the incentive compatible methods. E.g., Wertenbroch and Skiera (2002) find that the WTP for cake and Coke is more strongly correlated with hunger or thirst and also with the evaluation of the purchase in the case of incentive compatible methods than in the case of stated preferences. Another reason for the higher WTP measured by the stated-preferences method could also come from a downward bias of WTP measured by incentive-compatible methods. This issue has not been raised so far, and at this point the studies neither support nor contradict this possibility. We expand on this idea later in this paper when we discuss our model. We can further investigate the behavioral incentive compatibility by comparing the WTP that results from different incentive-compatible methods. The few studies that use this approach show that different methods do not lead to the same WTP distributions (Shogren et al. (2001a); Rutstrm (1998)). The information content of this finding is limited. It indicates that at best, only one of the two methods provides empirically incentive-compatible results, but we cannot determine which one of the two it is, if any.

1 See Cummings, Harrison, and Rutstrm (1995); Schulze et al. (1996); Fox et al. (1998); Wertenbroch and Skiera (2002); Balistreri, McClelland, and Schulze (2001); for a different result see Sattler and Nitschke (2003).

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The overall picture that can be drawn from all these results is still somewhat incomplete. The number of results is still too small and the results themselves are partly contradictory, especially in the case of WTP values for real products, which are relevant in marketing. We designed the following experiment to help complete this picture. 3 AN EXPERIMENT TESTING INCENTIVE- COMPATIBLE METHODS FOR THE ELICITATION OF WTP

3.1 DESIGN AND PROCEDURE The goal of the experiment is to test the behavioral incentive compatibility of the Vickrey auction and the BDM mechanism with the help of indicators, and to determine the effect of the incentive-compatible methods compared to the stated-preferences method. To accomplish our goals, we used a between-subjects design to ensure that no prior experience with the other methods could lead to confusion about strategy, as might be the case in a within-subjects design. We conducted all experiments in class with first-year students majoring in business or economics at the Goethe-University Frankfurt, Germany, over a two-week period from Nov 25, 2002 to Dec 5, 2002. The sample size was n = 101 for the Vickrey auction, n = 33 for the BDM-mechanism and n = 27 for the stated-preferences question, which took the form of an open-endedquestion (OEQ). We asked for WTP for a bar of chocolate imported from France just for this purpose and not available in Germany at the time of the experiment. Subjects were told that it was a 200g bar of white chocolate with nuts and cracknel, manufactured by the French traditional brand Poulain. We chose this product because it was new to the subjects, and because it was affordable due to its relatively low price, yet supposedly interesting for the majority. We then gave the chocolate to the subjects to look at and to try a piece. Then we explained the respective method to every experimental group. For the incentive-compatible methods, we gave a numerical example to illustrate the dominant strategy and the disadvantages of overbidding and underbidding. To avoid anchoring as much as possible, our example used a different price range from that of the chocolate price range. We encouraged students to ask questions, and some did. We also stressed that all bids were binding and that winners would be obliged to purchase the chocolate. In the Vickrey auction, subjects then submitted their bids. To accommodate the large group, we used a multiple units generalization of the Vickrey auction and determined the number of units so as to obtain a share of winners of one out of seven bidders, which is an average of previous studies. While the bids were being sorted, the subjects answered a questionnaire that included questions about product involvement, comprehension, and bidding strategy. Then we announced the winners and the resulting price, and the products were sold. Subjects then answered a second questionnaire with questions on the outcome of the auction.

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The procedure in the BDM group was similar. In contrast to the usual version of drawing individual random prices, here, due to time constraints, a single random price was drawn for the whole group, but we believed that this modification would not affect the results. The random price was drawn from a uniform distribution in the interval from 1 to 2 , which was not known to the subjects. If they asked, they were informed that all possible prices were realistic. In the stated-preferences group, subjects were not given the opportunity to buy the chocolate. They only had to answer a questionnaire with an OEQ about their WTP for the chocolate, and some other questions. 3.2 TESTS OF BEHAVIORAL INCENTIVE COMPATIBILITY We conducted tests with the help of two indicators of overbidding and underbidding. We obtained these indicators from the second questionnaire after the announcement of the winners and the resulting prices. First, subjects evaluated the purchase occasion at the resulting price on an 11-point scale from much too expensive to a very good deal. In combination with the subjects success in the auction or BDM, we were able to ascertain their bidding strategy. Winners (who should have earned a non-negative consumer surplus at the actual selling price) who judged the product too expensive had obviously bid too much, but losers (who should have earned a negative consumer surplus in case they had to buy the chocolate bar at the actual selling price) who thought the product was a good deal had apparently underbid. We believe that this indicator yields valid results, as the situation closely resembles a real shopping situation in which the price is given and subjects need to evaluate the purchase occasion at this given price. Furthermore, subjects saw how the products were sold to the winners, which renders the evaluation question highly realistic and involving. Second, we asked whether the losers would revise their bids upwards if they had one more opportunity to buy the chocolate. The underbidding is indicated by the share of the losers who revise their bids, and by the amount of the revision. 3.3 RESULTS First, we present the results of the two indicators2. The first indicator classifies 24% (22%) of the subjects in the Vickrey auction (BDM) as underbidders (negative consumer surplus but positive purchase evaluation) and 7% (9%) of subjects as overbidders (see table 1 ).

The data and analysis are available upon request from the authors.

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Negative consumer surplus (WTP < p) Evaluation: Purchase is a good deal Evaluation: Product is too expensive Underbidding Vickrey: 24% of subjects BDM: 22% of subjects Truthful bidding Positive consumer surplus (WTP > p) Truthful bidding Overbidding Vickrey: 9% of subjects BDM: 7% of subjects

For both methods, the proportion of underbidders is significantly higher than the proportion of overbidders (at the 5% level). The scope of underbidding indicated by the second indicator is also relatively high [see table 2]. The share of losers revising their bids is 47% for the Vickrey auction and 41% for the BDM mechanism, and the average revision is 0.30 for the Vickrey auction and 0.24 for BDM (both means significantly larger than zero, p=0,000 and p=0,003, respectively). So both indicators are high, which reinforces the results of strong underbidding.

Table 2: Revision of bids in the incentive compatible methods

Share of losers revising their bids Vickrey BDM 47% 41% Average revision in 0,30 0,24

To compare the WTP distributions of all three methods, we present boxplots in figure 1.

Figure 1: Boxplots of WTP for the Vickrey auction, BDM mechanism and open-ended question (medians: Vickrey 0.6 , BDM 0.99 , OEQ 1.25 )

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The hypothetical answers to the OEQ are signficantly above the WTP from the incentive compatible methods (p < 0.05). This finding is consistent with the results in the literature. However, we doubt that the discrepancy can be explained by only a hypothetical bias of the stated preferences. Rather, we suggest that at least part of this deviation is due to a downward bias, as indicated by the strong tendency towards underbidding in the Vickrey auction and the BDM mechanism. We can also state that the BDM mechanism yields higher WTP values than that of the Vickrey auction, which is not surprising, given the somewhat higher tendency towards underbidding in the latter. The difference between the results of the two methods may be caused by different speculations about the WTP of other bidders in the Vickrey auction and about the price range of the random draw in the BDM mechanism. Instead of further exploring these deviations from rational behaviour (Ruprecht (2005)), we concentrate on the downward bias that seems to be inherent in both methods. 4 A MODEL OF BIDDING UNDER UNCERTAIN WTP How can this bias, which is rather strong, be explained? In this section, we modify the standard bidding model for the case of uncertain WTP, which yields one possible explanation. 4.1 THE NOTION OF UNCERTAIN WTP The proof of theoretical incentive compatibility relies on the usual assumption of microeconomic preference theory, that subjects know their own preferences (Von Neumann and Morgenstern (1947); Savage (1972); McAfee and McMillan (1987)). However, this assumption may not always apply. The behavioral literature stresses that in general, preferences are not necessarily known by the subjects and may be unstable over time (Kahneman and Snell (1992)), valuations are initially malleable (Ariely, Loewenstein, and Prelec (2003)). Also, WTP as a special formulation of preference is a construct that is unfamiliar to subjects, who normally only decide whether to buy a product at a given price. Apparently subjects experience great cognitive difficulty reporting their exact WTP when asked an open-ended question (Brown et al. (1996); Gregory et al. (1995); Ready, Whitehead, and Blomquist (1994)). The same may be true when subjects are asked to offer a bid in the context of an auction or BDM mechanism. Some literature on auctions acknowledges the need for WTP formation by subjects (Shogren et al. (2001a); Chakravarti et al. (2002, 290)). Surprisingly, this notion of uncertain WTP has not led to an analysis of the consequences that this uncertainty has on bidding strategy. Here, we drop the assumption that subjects really know their own WTP and instead investigate the consequences on bidding strategy.

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4.2 DISCRIMINAL DISPERSION AS A PERCEPTION ERROR Uncertainty about preferences by subjects can be conceptualized with the random utility model framework for discrete choice analysis (Hanemann (1984); Koning and Ridder (2003)). There, the utility of an alternative A is composed of a systematic utility component UA and a random utility component . In analogy, we can define WTP (= Z ) as consisting __ of a systematic component Z and a random component 3. This notion of a random part of WTP is similar to the concept of a discriminal dispersion which was introduced in the psychometric literature by L. L. Thurstone (1927; 1959). Thurstone used it to describe the haziness in perception that leads to a normal distribution instead of a deterministic value when subjects evaluate or perceive a psychological quantity such as the beauty of a painting or the severity of a crime. The true value of this respective quantity equals the mean of the distribution, and errors are symmetric around the mean. In the context of WTP elicitation, this means that subjects who aim at their true WTP can make a kind of measurement error and report a higher or lower value by mistake. For example, the reader may ask if she is able to find the true value of her WTP for a bar of the new chocolate brand just at this moment. Would they be able to report the right number, so that they were sure that five cents less would be not enough and a penny more would be too much? The subjects in a Vickrey auction or BDM face double uncertainty as a consequence of the discriminal dispersion. They are not only uncertain about the WTP of other bidders in the auction or about the price range in the BDM mechanism, but also about their own WTP. We show that this uncertainty will cause rational but risk-averse bidders to systematically underestimate their WTP. The intuition of the formal proof is as follows: imagine a subject who approaches her WTP cautiously from below and keeps a safe distance, because if she overestimates, she might incur a loss that can be prevented by underestimating her WTP. On the other hand, underestimation cannot result in a loss. 4.3 OPTIMAL BIDDING UNDER CERTAIN WTP Before modelling the optimal bidding strategy under discriminal dispersion, we outline the case of certainty as a benchmark. The proofs of theoretical incentive compatibility for the two mechanisms go back to Vickrey (1961) and Becker, DeGroot, and Marschak (1964), respectively, and can be formalized within an expected-utility-framework (e.g., Cox, Roberson, and Smith (1982)). The following expositions build on that framework. The__ surplus S of a bidder with WTP Z who wins the product at price p can be written as S = Z p. Let f (p) denote the density function of the resulting price in the Vickrey auction or BDM mechanism, with b being the lowest possible price. Then the expected surplus for the subject bidding Z * is:

3 We thank Prof. Dr. Ingo Balderjahn for this analogy.

__

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(1)

E [S(p)] =

b

z*

( Z p) f (p)dp

__

We assume that all bidders expect a uniform distribution for the price in the interval [b, c]. This assumption enables us to illustrate our model without restricting the validity of our results. Figure 2 shows the surplus of a bidder as a function of the price if she receives the product at this price. The surplus is a straight line S(p) = __ __ Z - p in the interval [b, c] with the slope -1. We note that a bidder who bids under her Z __ can expect, if she wins, a positive surplus as the price will__ smaller than Z. If she overbe __ bids, the bidder may also find herself on the right side of Z if p turns out to be > Z, where she has to expect a loss. Obviously, the dominant strategy is to bid ones exact WTP. Then the expected surplus equals the areas I + II, weighted with the probability 1/(c b). Because all areas in the following comparisons are equally weighted, we ignore this weighting factor in the rest of the paper. If the bidder underbids and reports, e.g., only Z , the expected surplus shrinks to area I. If she overbids and reports, e.g., Z+, the surplus diminishes as the loss area III is added. Therefore, the best strategy of a rational bidder who wishes to maximize her expected profit is to bid her exact WTP. Keep in mind that in this utility formulation there is no other utility than the monetary surplus (as the utility of the product is already included in the WTP). This also implies that if a bidder loses the product because of underbidding, then the utility is zero, and there is no disutility. We return to this issue later.

Figure 2: Surplus as a function of price

4.4 OPTIMAL BIDDING UNDER DISCRIMINAL DISPERSION AND AVERAGE WTP How does the optimal bidding strategy change when rational bidders try to find their true WTP but encounter a discriminal dispersion? We investigate the consequences for two __ __ possible symmetrical perception errors, Z - Z = Z + Z. We also assume for now that

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the mean of the discriminal dispersion Z coincides with the mean of the uniform price distribution ((c + b)/2) (see figure 3).

Figure 3: Discriminal dispersion and price distribution

__

In this case the bidder is on margin (Shogren et al. (2001b)), which means she assumes that she has an average WTP compared to the other bidders in the auction or to the possible price range for BDM. Note that this also includes the case in which a bidder has no idea about the other bidders WTP or the price range, since the bidder has no reason to assume that her WTP is higher or lower than average, due to Laplaces principle of insufficient reason. First, we consider the case of underestimation that leads to a bid of Z . The expected surplus then equals area I in figure 2. We can obtain the same result by computing the integral according to equation 1 [see appendix ]. Next, we consider the case of overestimation by the same absolute __ amount, which leads to a __ of Z+. The expected surplus now equals areas I + II (for p < Z ) minus area III (for bid p > Z ). Due to the symmetry of the perception error, areas II and III are equal, except for the sign, and cancel out. The excepted surplus in the case of overestimation therefore amounts to area (I + II III =) I and is the same as in the case of underestimation [also see appendix for the integral formulation]. This means that a risk-neutral bidder is indifferent between a positive and a negative perception error of the same amount. Furthermore, figure 2 shows that the expected surplus is higher when the perception error is smaller, and vice versa. We can conclude that a rational bidder should try to determine her WTP as accurately as possible and keep the perception error small. This notion reflects the idea of bounded rationality as formulated by H. Simon (1957) that subjects act intendedly rational, but only limitedly so. What conclusions can we draw for a risk-averse bidder? We can infer the risk associated with overestimation and underestimation from figure 2. First, the range of possible

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outcomes is larger for overestimation [Z b, Z Z +] than for underestimation [ Z b, __ Z Z ]. Second, underestimation produces only a positive surplus (area I), but overestimation can lead to losses (area III). So for both risk measures, risk is higher in the case in which WTP is overestimated. Thus, a risk-averse bidder with average WTP would prefer to underestimate than overestimate her WTP, if she cannot name it exactly due to discriminal dispersion. If we accept risk aversion as the prevailing risk attitude4 for WTP elicitation, then we have given an explanation for the downward bias of the incentive compatible methods found in our experiment. 4.5 OPTIMAL BIDDING UNDER DISCRIMINAL DISPERSION AND HIGH OR LOW WTP Now, we assume an off margin bidder, i.e., one whose WTP Z is higher or lower than average. We assume that the perception errors are unchanged. Figure 4 shows for a high WTP that the surplus function moves to the right. As a result, area I is enlarged while areas II and III remain the same (as long as Z +< c which we assume for now). This means that expected surplus increases compared with that of an on margin bidder, but remains identical for overestimation and underestimation.

Figure 4: Consequences of overestimation and underestimation for high WTP

__

__

__

__

How has the risk changed? Overestimation has become less risky as the share of the expected loss (area III) to the expected positive surplus (areas I + II) has diminished. A comparison of the range of outcomes for overestimation and underestimation produces the same result, that overestimation is now relatively less risky. However, it is still more risky than underestimation in absolute terms. In the other case of a low WTP, the result is the opposite. We can now summarize both cases: in a Vickrey auction or BDM mechanism, risk-averse bidders who feel to have a

4 This is the usual assumption in portfolio theory, where investors are said to prefer less variance in their returns to more (e.g., Markowitz (1952); Rudolph (1979); Mehra and Prescott (1985)).

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relatively high (low) WTP have a weaker (stronger) tendency towards underestimation of their WTP than do bidders with average WTP. Next, we look at bidders with extremely high or low WTP. The term extreme denotes a WTP that is situated so far from the mean of the price distribution that the perception error lies__outside of the boundaries of the interval [b,c ]. If there is an extremely high WTP Z close to the upper bound c, part of the loss area is cut off [see figure 5 ], resulting in a higher expected surplus for the case of overestimation (I + II - III) than for the case of underestimation (I). Therefore, a risk-neutral bidder with extremely high WTP will tend to overestimate rather than underestimate her WTP.

Figure 5: Overestimation with very high WTP so that Z + > c

At the same time, the risk inherent in overestimation diminishes, but the risk associated with underestimation increases, both in relation to the situation of average WTP. However, there is still more risk in overestimation. How will that affect a risk-averse bidder? The answer depends on the degree of risk aversion. A bidder with low risk aversion will overestimate, if the higher risk is more than compensated by the higher surplus of overestimation. Only a bidder who is strongly risk averse and has an extremely high WTP will underestimate her WTP. We now consider the opposite and assume a bidders WTP to be extremely low. In the case of underestimation, the bidder cannot win in the auction or in the BDM mechanism, because Z < b, the expected surplus, is zero. Overestimation even produces a negative expected surplus as the loss area III becomes larger than area II (area I has disappeared). As a consequence, bidders with extremely low WTP should be strongly inclined to underestimate their WTP, and this result does not depend on the bidders risk attitude. 5 SUMMARY OF RESULTS In section 3 we reported experimental results of strong underbidding in the Vickrey auction and BDM mechanism. As an explanation, we have developed a modi-

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fication of the standard bidding model. Our modification is based on the concept of discriminal dispersion, which goes back to Thurstone (1927). It is similar to the random utility assumption in choice models. Under the assumption of rational and risk-averse bidders, we can make the following predictions: Risk-averse bidders, who either assume they have an average WTP or have no idea about their relative WTP, tend to underestimate their WTP. Due to the uncertainty about their true WTP, they prefer to be careful and bid lower rather than higher values. For risk-averse bidders who feel that their WTP is higher than average, the tendency towards underestimation is weaker, or can even turn into overestimation if the degree of risk aversion is low. For risk-averse bidders who assume that their WTP is lower than average, the tendency towards underestimation is strongest. In this case, underestimation can be optimal even for risk-neutral bidders. We can confirm these relations between bidding and relative WTP with the data from our experiment. The bidders in Vickrey and BDM who are classified as overbidders [recall table 1] bid significantly (p < 0.001) higher than did underbidders [see table 3].

Table 3: Relationship between bidding and relative WTP

Range of bids Overbidders Underbidders 1.69 2.99 0 1.50 Mean bid 2.11 0.81

6 CONCLUSION In experimental economics, the Vickrey auction and the BDM mechanism are applied to elicit WTP as indicators of the relative attractiveness of options in experimental choice situations and market simulations. In marketing applications, these two incentive-compatible methods promise to enhance the information basis for pricing, if the WTP elicited with these methods are more valid than are the WTP elicited with the help of traditional methods. But are the WTP data obtained with the incentive compatible methods really more valid? Both the Vickrey auction and the BDM mechanism implicitly assume that subjects know their exact WTP. Then it is the dominant strategy to reveal their WTP. Empirical findings of violations of the dominant strategy are usually attributed to irrational behavior. An alternative explanation, at least for underbidding, is the concept of a discriminal dispersion. We have shown that it can be rational for bidders

50

BIDDING STRATEGIES

to underestimate their WTP if they are risk averse. The lower the WTP, the stronger this tendency towards undererstimation. Thus, incentive-compatible methods no longer yield valid results when discriminal dispersion applies. Future research must show if our hypothesis of underbidding due to a discriminal dispersion of WTP can be confirmed in other empirical studies. Should our hypothesis of a systematic downward bias be confirmed it would be important to know the size of the bias, its persistence and its determinants. Replications and other method comparisons as well as investigations in other product categories seem well worthwhile. Subjects might exhibit a lower preference uncertainty with familiar products than with new products, which implies that underbidding should be lower. The same might be true for high involvement versus low involvement products. These arguments apply to the shape of the discriminal dispersion. Other parameters of interest that would need to be studied empirically include the price range and the shape of the price distribution. Finally, model extensions to other utility formulations appear as a promising area of future research. As an alternative to expected utility theory, prospect theory (Kahneman and Tversky (1979)) would predict an even more negative evaluation of losses, thus making underestimation of WTP stronger. Another possible extension would be regret theory (Bell (1982), Loomes and Sugden (1982)). Regret could arise when a bidder accidentally bids the wrong WTP value which leads to an outcome worse than the outcome she would have achieved with the right value. In case of overestimation a monetary loss can be the result, as demonstrated above. This leads not only to a decreasing expected value but also to an additional disutility accounting for the regret of having missed a better outcome. In case of underestimation, the bidder risks not getting the product and a possible consumer surplus. Under expected utility theory this is not counted as a loss, since the monetary wealth of the bidder remains unchanged (see above). However, there can be regret for forgoing a possible gain due to underestimation, if the bidder knows only after the auction that she would have been willing to pay the resulting price or even more. Therefore utility in this case would be negative after subtracting the disutility due to regret from the expected value of 0. An interesting question here is whether a bidder perceives the risk of a real monetary loss equal to the risk of an equivalent foregone gain, and whether the foregone gain is viewed strictly in monetary terms or rather as the loss of the product. The impact of regret when losing the product might also depend on the uniqueness of the product: if a product is unique like, e.g., tickets for an event, then regret would probably be higher. One theory that is possibly applicable to these questions is mental accounting (Thaler (1980)). Different mental accounts might be used for products than for monetary gains and losses, and calculation rules might differ for products in different product categories if they belong to different mental accounts. At this point we do not have clear suggestions as to how exactly this works, but we believe that mental accounting of outcomes of bidding strategies constitutes one fertile area of future research.

51

REFERENCES

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Kagel, John H., Ronald M. Harstad, and Dan Levin (1987), Information Impact and Allocation Rules in Auctions with Affiliated Private Values: A Laboratory Study, Econometrica 55, 1275-1304. Kagel, John H. and Dan Levin (1993), Independent private value auctions: Bidder behavior in first-, second- and third-price auctions with varying numbers of bidders, Economic Journal 103, 868-79. Kahneman, Daniel and Amos Tversky (1979), Prospect Theory: An Analysis of Decision under Risk, Econometrica, 47, 263-91. Kahneman, Daniel and Jackie Snell (1992), Predicting a changing taste: do people know what they will like? Journal of Behavioral Decision Making, 5, 187-200. Koning, Ruud H. and Geert Ridder (2003), Discrete Choice and Stochastic Utility Maximization, Econometrics Journal 6, 1-27. Loomes, Graham and Robert Sugden (1982), Regret Theory: An Alternative Theory of Rational Choice under Uncertainty, Economic Journal 92, 805-824. Markowitz, Harry (1952), Portfolio Selection, Journal of Finance 7, 77-91. McAfee, R. Preston and John McMillan (1987), Auctions and Bidding, Journal of Economic Literature 25, 699-728. Mehra, Rajnish and Edward C. Prescott (1985), The Equity Premium Puzzle, Journal of Monetary Economics 15, 145-61. Ready, Richard C., John C. Whitehead, and Glenn C. Blomquist (1994), Contingent Valuation When Respondents Are Ambivalent, Journal of Environmental Economics and Management 29, 181-196. Rudolph, Bernd (1979), Zur Theorie des Kapitalmarktes, Grundlagen, Erweiterungen und Anwendungsbereiche des Capital Asset Pricing Model (CAPM), Zeitschrift fr Betriebswirtschaft 11, 1034-1067. Ruprecht, Heidrun (2005), Anreizkompatible Verfahren zur Erhebung von Zahlungsbereitschaften, Dissertation, Goethe-University Frankfurt am Main. Rutstrm, E. Elisabet (1998), Home-Grown Values and the Design of Incentive Compatible Auctions, International Journal of Game Theory 27, 427-441. Sattler, Henrik and Thomas Nitschke (2003), Ein empirischer Vergleich von Instrumenten zur Erhebung von Zahlungsbereitschaften, zfbf 55, 364-381. Savage, Leonard J. (1972), The foundations of statistics, 2nd rev. ed, New York: Dover Publications. Schulze, William, Gary McClelland, Donald Waldman, and Jeffrey Lazo (1996), Sources of Bias in Contingent Valuation, in Bjornstad, David J. and James R. Kahn (eds.), The Contingent Valuation of Environmental Resources - Methodological Issues and Research Needs, Cheltenham and Brookfield: Edward Elgar Publishing, 97-116. Shogren, Jason F., Sungwon Cho, Cannon Koo, John List, Changwon Park, Pablo Polo, and Robert Wilhelmi (2001), Auction mechanisms and the measurement of WTP and WTA, Resource and Energy Economics, 97-109. Shogren, Jason F., Cannon Koo, Michael Margolis, and John A. List (2001), A random nth-price auction, Journal of Economic Behavior and Organization 46, 409-421. Simon, Herbert (1957), Models of Man: social and rational; mathematical essays on rational human behavior in a social setting, New York et al.: Wiley. Skiera, Bernd and Inken Revenstorff (1999), Auktionen als Instrument zur Erhebung von Zahlungsbereitschaften, zfbf 51, 224-242. Smith, Vernon L. (1976), Experimental Economics: Induced Value Theory, The American Economic Review 66, Papers and Proceedings of the Eighty-eighth Meeting of the American Economic Association, 274-279. Sonnegrd, Joakim (1996), An experimental Examination of Parallelism in Single-Unit Vickrey and English Auctions, Working Paper, University of Stockholm. Thaler, Richard (1980), Toward a positive theory of consumer choice, Journal of Economic Behavior and Organization 1, 39-60. Thurstone, Louis L. (1927), A Law of Comparative Judgment, Psychological Review 34, 273-286. Thurstone, Louis L. (1959), The Measurement of Values, Chicago and London: University of Chicago Press.

53

Vickrey, William (1961), Counter Speculation, Auctions and Competitive Sealed Tenders, Journal of Finance 16, 8-37. Von Neumann, John and Oskar Morgenstern (1947), Theory of games and economic behavior, 2nd ed., Princeton: Princeton University Press. Wertenbroch, Klaus and Bernd Skiera (2002), Measuring Consumer Willingness to Pay at the Point of Purchase, Journal of Marketing Research 39, 228-241.

APPENDIX CALCULATION OF EXPECTED SURPLUS FOR BIDDERS WITH AVERAGE OVERESTIMATE THEIR WTP Expected surplus in the case of underestimation The probability of winning at bid Z equals the probability that b < p Z . In this case, __ consumer surplus is Z p (note that surplus is computed from the true WTP). Then the expected surplus is: (2)

1 E [S - (p)] = (Z p) ___ dp cb

b Z __

(3)

E [S -

__

__

__

__

c-b

2(c b)

c-b

2(c b)

__

2(c-b )

(4) (5)

__

__

__

__

__

__

2(c b)

__

2(c-b )

2(c-b )

E [S -

__

54

BIDDING STRATEGIES

Expected surplus in the case of overestimation In the case of overestimation, losses are possible, depending on the resulting price. The __ probability of a positive surplus is the probability that b < p Z , the probability of a __ loss is the probability that Z < p Z +. The expected surplus is: (6) E [S + (p)] =

b Z

__

1 (Z p) __ dp + __ cb

__

__

Z+

1 (Z p) __ dp cb

__

(7)

E [S +

__ __

__

] [

__

__

(8)

__

__

__

c-b

__

2(c-b )

__

c-b

2(c-b )

c-b

__

2(c-b )

c-b

2(c-b)

(9)

E [S +

__

(10)

2(c-b )

2(c-b )

Equations (5) and (10) show that expected surplus is equal__ overestimation and underfor __ estimation because we assume symmetry ( Z Z = Z + Z ).

55

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