MANAGERIAL ECONOMICS:

THEORY, APPLICATIONS, AND CASES

W. Bruce Allen | Keith Weigelt | Neil Doherty | Edwin Mansfield

CHAPTER 12

Auctions
OBJECTIVES
• Explain how managers can apply game
theory to the analysis of auctions
• Describe the importance of auction
mechanisms and their use in strategic
decisions related to negotiations and
monopoly markets
A SHORT HISTORY OF
AUCTIONS
• Babylonian marriage market described by
Herodotus (circa 300 BCE)
• The most beautiful women were auctioned first at
the highest prices.
• Less attractive women were auctioned for
negative bids. The man with the highest negative
bid got the woman and also got paid for it from
the positive bids tendered for the beautiful
women.
• Auction use expanded rapidly with the
development of the Internet and e-commerce
in the 1990s.
TYPES OF AUCTION
MECHANISMS
• English or Ascending-Bid Auction
• Reserve price: The lowest price at which a seller
is willing to sell a product; also called a
reservation price
• Japanese auction: Auction in which bidders bid
until the price exceeds their reservation price
• Ascending-bid time auction: Auction in which the
bidding continues for a specified time
• Sniping: When bidders use programs to ensure
that they submit the last-second best bid
TYPES OF AUCTION
MECHANISMS
• Dutch or Descending-Bid Auction
• Dutch auction: A descending-bid system in which initial
prices are set very high and are lowered at set intervals
until accepted by bidders
• Sealed-Bid Auction
• Second-Price, Sealed-Bid Auction
• Vickrey auctions: Second-price, sealed-bid
auctions in which the highest bidder receives the
good or service at the bid price of the second-
highest bidder
AUCTION MECHANISM AND
REVENUE GENERATION
• Assumptions
• Bidders are symmetric.
• Bidders with identical reservation prices who
observe the same signal will submit the same
bids.
• Bidders have similar distributions of valuation
that are known to all.
• Reservation prices may differ across bidders.
• Bidders are risk-neutral.
• Bidders maximize expected value.
AUCTION MECHANISM AND
REVENUE GENERATION
• Assumptions (Continued)
• Signals are independent.
• Reservation prices are a function of information and
utility.
• In private-value auctions, signals are independent if
reservation prices depend on utility (experience) rather
than information (about the value of the good at
auction).
• In common-value auctions, signals are independent if
reservations prices are the same for all bidders, but the
true value of the good at auction is unknown.
AUCTION MECHANISM AND
REVENUE GENERATION
• Taxonomy of auctions
• Private-value auctions: Auctions in which
reservation prices are a function of
information and utility
• Common-value auctions: Auctions in
which all bidders value the good similarly
AUCTION MECHANISM AND
REVENUE GENERATION
• Revenue equivalence theorem shows that
the type of auction a manager chooses does
not affect the auction's expected total
surplus and hence does not affect the
expected revenues
• Notation
• b = bid
• p = price paid by winning bidder
• PrW = probability of winning the auction
• Expected profit = PrW(b – p)
• Expected profit is the same for the four types of
auctions.
BIDDING STRATEGIES
• Dominant strategy: Bidders should
always be willing to bid up to their
reservation prices.
• If the current bid is higher than or equal
to your reservation price, don’t bid.
• If the current bid is lower than your
reservation price, increase the bid.
BIDDING STRATEGIES
• English or ascending bid auction
• Bidders gain information about rivals' reservation
prices, but it is irrelevant to the optimal bid.
• The difference between the reservation price of
the second-highest bidder and that of the
highest bidder, minus the minimum necessary
incremental bid, is the potential surplus.
• The optimal winning bid is equal to the bid made
by the bidder with the second-highest
reservation price plus the minimum necessary
additional increment to win the auction.
BIDDING STRATEGIES
• Vickrey auction
• Winning bidder pays the amount bid by
the second-highest bidder, so the bidder's
surplus is equal to the difference between
the second-highest bidder's reservation
price and the winner’s reservation price.
BIDDING STRATEGIES
• Descending auctions or first-price sealed-bid
auctions
• Bidders should bid their estimates of the
reservation price of the second-highest bidder
and, assuming that all bidders bid less than their
actual reservation price, the bidder with the
highest reservation price will win the auction.
• The more bidders there are, the closer a person’s
bid should be to his or her reservation price.
BIDDING STRATEGIES
• Descending auctions or first-price
sealed-bid auctions
• Optimal bidding strategy
• B = v – [(v – L)/n]
• B = optimal bid
• v = bidder’s reservation price
• L = lowest possible bid
• n = number of bidders
BIDDING STRATEGIES
• Descending auctions or first-price sealed-bid
auctions (Continued)
• Example
• v=3
• L=0
• B = 3 – [(3 – 0)/2] = $1.50 for n = 2
• B = 3 – [(3 – 0)/3] = $2.00 for n = 3
BIDDING STRATEGIES
• Incentive-compatible
• Type of rule that encourages managers to
reveal their true preferences
STRATEGIES FOR SELLERS
• Optimal pricing strategy depends on
the distribution of reservation prices
across bidders.
• Figure 12.1: Relationship between the
Sellers’ Expected Revenue and the
Winning Bidders’ Expected Marginal
Revenue
STRATEGIES FOR SELLERS
• Optimal pricing strategy depends on the
distribution of reservation prices across
bidders. (Continued)
• Example
• Distribution of reservation prices = F(b)
• Probability that bid b will be the winning bid = 1 – F(b)
• Optimal reserve price = (value of the object up for
auction, if it does not sell) + (half the managerial
estimate of the highest reservation price)
• Table 12.1: Auction
• Table 12.2: Posted Price
VALUE OF INFORMATION
• Repurchase Tender Offers (RTO)
• Repurchase tender offers: Offer used by
managers to buy back stock shares from current
shareholders
• Typically priced at a premium over market price
• Prior to 1981, RTOs were fixed price and supply
was estimated.
• Since 1981, the use of a modified Dutch auction
format has been more commonly used.
• Generally allows a firm to acquire shares at a lower
total cost
VALUE OF INFORMATION
• Repurchase Tender Offers (RTO)
(Continued)
• Modified Dutch auction
• The firm announces a range of prices at which they are
willing to repurchase tendered shares, with the
minimum set at a small premium over current market
valuation.
• Shareholders willing to tender send a price schedule
that indicates the number of shares they are willing to
sell at each price.
• The firm can then construct a price schedule and,
based on the number of shares it wishes to repurchase,
determine the optimal pricing strategy.
VALUE OF INFORMATION
• Repurchase Tender Offers (RTO)
(Continued)
• Example: Citizens First Financial Corp. (CFFC)
• CFFC believes the share price of their stock will rise to
$20 in the near future.
• Table 12.3: Shareholder Supply Schedule—Three
scenarios
• A fixed price of $15 maximizes expected profit
($1,685,000).
• Using a modified Dutch auction, managers have perfect
information about the shareholder supply schedule and
can set price accordingly. This results in a higher
expected profit ($1,700,000).
RISK AVERSION
• In second-price auctions, risk aversion
has no effect on the optimal bidding
strategy.
RISK AVERSION
• First-price auctions
• A risk-averse bidder will bid higher than a risk-
neutral bidder (although not higher than his or
her reservation price), with the difference equal
to a risk premium representing "bidding
insurance" that makes it more likely that the
bidder will win.
• Sellers prefer a first-price auction because it
causes bidders to reveal their risk preferences
and premiums and because it reduces the
variability in expected return compared to
second-price auctions.
NUMBER OF BIDDERS
• Auction markets have many buyers
(bidders) and only one, or a few,
sellers.
• The more bidders there are in an
auction market, the higher is the
expected price.
NUMBER OF BIDDERS
• Example
• Assume that bidder reservation prices are
uniformly distributed between zero and $100
• Seller's expected revenue = [(N - 1)/(N + 1)]
(Reservation price of bidders)
• As additional bidders enter an auction, the
expected revenue of the seller approaches the
reservation price.
WINNER’S CURSE
• Winner's curse: When the bidder with the
highest estimated value bids the most and
wins the auction, but the bid amount may
exceed the true value of the object
• Value of the thing being auctioned off is not
known with certainty, although it has the same
value to all bidders.
• In a sealed-bid, first-price auction, the bidder
with the highest estimated value (and bid) wins
the auction.
WINNER’S CURSE
• Issues
• A bidder with relatively less information
than others should bid lower.
• A bidder with relatively little confidence in
his or her estimate of the value of the
thing at auction should bid lower.
• The more bidders there are in the auction,
the lower the bid should be.
CONCERNS IN AUCTION
DESIGN
• The ability for bidders to collude is a
concern to sellers.
• Bidders form a "ring" in which no one bids
against the designated bidder. The things
that are purchased are then distributed
among members of the ring after the
auction.
• Colluding bidders do not bid up prices.
CONCERNS IN AUCTION
DESIGN
• The ability for the seller to attract
bidders is a concern to sellers.
• If it is clear to all bidders that one
particular bidder will win, they are less
likely to participate in the auction.
• If the seller sets a reserve price that is
too high, then bidders are less likely to
participate in the auction.
• If the seller sets a reserve price that is
too low, it encourages collusion.
 This concludes the
Lecture PowerPoint
presentation for Chapter 12

Visit the StudySpace at:

http://www.wwnorton.com/college/econ/mec7/

© 2009 W. W. Norton & Company, Inc.