Auctions and Bargaining Microeconomics Second Edition Chapter 17 Auctions and Bargaining If this PowerPoint presentation contains mathematical equations, you may need to check that your computer has the following installed: 1) MathType Plugin 2) Math Player (free versions available) 3) NVDA Reader (free versions available)

Learning Objective 17.1 Auctions 17.2 Bargaining

Key Ideas (1 of 2) Auctions are increasingly used to sell goods and services. There are four major types of auctions: English, Dutch, first-price and second-price auctions. Economic theory predicts that under certain assumptions they yield identical revenues for the seller.

Key Ideas (2 of 2) Bargaining is another frequent way that goods and services are exchanged. Bargaining power importantly determines the terms of exchange.

Auctions and Bargaining (1 of 2) Evidence-Based Economics Example: How should you bid in an eBay auction?

Auctions (1 of 2) Auction Market process in which potential buyers bid on a good and the highest bidder receives the good Tell students that the technology explosion has led to a change in the way we exchange goods and services. It has also led to a change in the amount of power consumers have in the market, leading to a greater ability to affect the market price than had been the case previously. It used to be that only rather unique goods were sold at auction—goods that didn’t have a market track record and that would be wanted by relatively few people. Technology has extended the reach of auctions so that now common goods are also sold this way.

Exhibit 17.2 Bidder Valuations for Raiders Tickets Auctions (2 of 2) Auction item: Two Oakland Raiders tickets being bid upon by five bidders Assume that bidders have private values that are unknown to other bidders and seller. Exhibit 17.2 Bidder Valuations for Raiders Tickets Bidder Value Ashley $250 Billy $200 Carol $150 Dalton $100 Eli $50 Ashley places the highest value on the tickets—she’s willing to pay up to $250 for them. Eli places the lowest value on the tickets, only being willing to pay up to $50 for them.

Auctions Types of Auctions (1 of 5) Auctions vary by How bids are placed How price is determined

Auctions Types of Auctions (2 of 5) How bids are placed: Open outcry auction Bids are public Sealed bid auction Bids are private so no bidder knows another’s bid

Auctions Types of Auctions (3 of 5) How price is determined: Sealed bid first-price auction Bidders privately submit bids at the same time with highest bidder winning item and paying amount of that bid

Auctions Types of Auctions (4 of 5) How price is determined: Sealed bid second-price auction Bidders privately submit bids at the same time with highest bidder winning item and paying the second highest bid

Auctions Types of Auctions (5 of 5) Four major types of auctions: Open-outcry: English auction Open-outcry: Dutch auction Sealed bid: first-price auction Sealed bid: second-price auction

Auctions Open-Outcry: English Auctions (1 of 4) Open-outcry auction in which the price increases until there is only one standing bid. The last bidder wins the item and pays the bid. Ask students what they think of when they hear the word “auction.” Have them describe the mechanics—how it progresses, how it is decided who wins. They will describe the English auction.

Auctions Open-Outcry: English Auctions (2 of 4) What is your optimal strategy to get the tickets? Bidding starts at $25. Everyone will be willing to bid. Bidding goes up to $50 This is Eli’s limit so he will drop out. Bidding goes to $100 Dalton is not willing to keep bidding since $100 is his limit.

Auctions Open-Outcry: English Auctions (3 of 4) Bidding goes up to $150 This is Carol’s limit so she drops out. Only Billy and Ashley are left. Assume Ashley bids $200. Billy will not bid because $200 is his limit—he is not willing to go over $200. Therefore, Ashley wins and pays $200 -- $50 less than her maximum amount.

Auctions Open-Outcry: English Auctions (4 of 4) The best strategy for everyone is to bid up to their highest value, which means the person with the highest value will get the item. = dominant strategy Remind students about the concept of dominant strategy—a player’s best strategy regardless of what other players do. Ask students what would have happened if Billy had bid $200 instead of Ashley. Would Ashley still have won the auction? Yes, because she could bid $200.01 and win the tickets.

Auctions Open-Outcry: Dutch Auctions (1 of 3) Dutch auction Open-outcry auction in which the price decreases until a bidder stops the auction. The bidder who stops the auction wins the item and pays that bid. Tell students that an English and Dutch auction are the same in that prices are called out loud and bidders react to them. The difference is that in an English auction, prices start low and go up, while in a Dutch auction, prices start high and decrease. Tell students that the U.S. Treasury uses the Dutch auction when it sells securities.

Auctions Open-Outcry: Dutch Auctions (2 of 3) What is your optimal strategy to get the tickets? Bidding starts at $500. No one bids since this is above everyone’s limit. Auction price then is lowered…down to $250. If you are Ashley, what do you do? Ask for a show of hands—how many would jump in at $250? Ask why. Ask those who wouldn’t pay the $250 why they would wait. Their answers will frame the trade-off associated with Ashley’s dilemma. If she jumps in, she gets the tickets, but she gets zero surplus. If she waits, her surplus goes up, but she risks losing the tickets.

Auctions Open-Outcry: Dutch Auctions (3 of 3) Let’s assume Ashley is risk-neutral. Ashley knows how many bidders there are, but doesn’t know their highest values. Optimal bid = 4/5 ($250) = $200 Tell students that once the bidding gets to $250 and no one has jumped in, Ashley assumes that others might have a lower value than she does—but she doesn’t know how low. Since there are 4 other bidders, she can assume that the next highest value is 80% of hers. Have students notice that when the number of bidders falls -- say to only two -- Ashley would be willing to wait for the price to fall to $125 (1/2 x $250), which should make sense—the more bidders, the more uncertainty about their values and the greater the likelihood someone will jump in. Also have students notice that the same person wins, but the winning bid is not necessarily always the same.

Auctions Sealed Bid: First-Price Auction Unlike open outcry auctions, sealed bid auctions are private and bids are submitted simultaneously. If you are Ashley, what do you bid? Ask how many would bid $250? Again, ask why. Lead students to understand that Ashley’s dilemma here is exactly the same as it was in the Dutch auction—bidding enough to win the tickets, but not so much that she doesn’t get any surplus. So she should bid $200, and everyone else should bid 4/5 of his or her maximum value. So Ashley wins the tickets and gets $50 of surplus.

Auctions Sealed Bid: Second-Price Auction (1 of 7) This method is unique—the winner does not pay his/her bid. Instead the winner pays the second-highest bid. What should Ashley bid?

Auctions Sealed Bid: Second-Price Auction (2 of 7) Ashley has 3 choices: Bid more than $250 Bid less than $250 Bid exactly $250 Tell students you will look at each of these options in turn.

Auctions Sealed Bid: Second-Price Auction (3 of 7) Should she bid more than $250? First outcome: the second-highest bid is lower than $250. If this is the case, she would have done just as well by bidding her value—she gains nothing by bidding more than her value. Ask students why this might make sense: it would increase her chances of winning and since she only has to pay the second-highest bid, she might still get some surplus. If the 2nd highest bid is less than $250, there’s no incentive for Ashley to bid anything other than $250—she wins and pays an amount less than her value.

Auctions Sealed Bid: Second-Price Auction (4 of 7) Should she bid more than $250? Second outcome: the second-highest bid is higher than $250. If Ashley “wins” she has to pay an amount that is greater than her value, leading to negative surplus. So Ashley should not bid more than $250.

Auctions Sealed Bid: Second-Price Auction (5 of 7) Should she bid less than $250? First outcome: other bids are very low, e.g., highest bid is $100 Ashley could win the auction by bidding her value and still pay $100. No advantage to bidding below $250. Ask students how many agree with this strategy.

Auctions Sealed Bid: Second-Price Auction (6 of 7) Should she bid less than $250? Second outcome: other bids are close to her value, e.g., highest bid is $200. If Ashley bids less than $200, she loses the tickets, even though she values them the highest. So Ashley should not bid less than $250.

Auctions Sealed Bid: Second-Price Auction (7 of 7) Should she bid exactly $250? Bidding exactly her value means she gets the tickets and gets some surplus. If everyone bids his or her value, she will get the tickets for $200, again getting $50 in surplus.

Auctions The Revenue Equivalence Theorem Exhibit 17.3 Summary of Revenue Determination in the Four Auction Types Agent English Auction Dutch Auction First-Price Auction Second-Price Bidder Bidder with highest value wins (Ashley at $200) (Ashley at $250) Seller Seller receives $200 Tell students that all four auctions and their outcomes are summarized in this table. So, in theory, all four auctions should result in the bidder with the highest value winning.

Auctions and Bargaining (2 of 2) Evidence-Based Economics Example: How should you bid in an eBay auction? So what does this theory tell us about how the real world works? Do people really behave this way? In experiments with online auctions, it seems that people do employ these optimal bidding strategies in the case of English and sealed bid second-price auctions. They do not exactly conform to the optimal bidding strategies in the case of Dutch and sealed bid first-price auctions, but they come close.

Bargaining There is another example of markets where the price is not fixed—markets where bargaining occurs. Ask how many students have ever participated in a market where bargaining exists. Ask if they think they got a good deal or if they felt they were “had.” Tell them that sometimes who gets the better deal depends on the circumstances rather than the individuals involved.

Bargaining What Determines Bargaining Outcomes? (1 of 3) Bargaining power The relative power an individual has in negotiations with another individual

Bargaining What Determines Bargaining Outcomes? (2 of 3) Bargaining power has two components: The cost of not coming to an agreement The influence of one participant over the other

Bargaining What Determines Bargaining Outcomes? (3 of 3) You have landed your dream job right after graduation—you start Monday morning. On Friday, your 15-year-old car dies. You see an ad for a perfect car in your price range, and you race to the used car lot. Four other potential buyers are also there.

Bargaining Bargaining in Action: The Ultimatum Game (1 of 2) Exhibit 17.4 The Ultimatum Game

Bargaining Bargaining in Action: The Ultimatum Game (2 of 2) If you were the Responder, would you accept one penny?

Bargaining Bargaining and the Coase Theorem (1 of 4) This is Adam and Barb. Adam wants a divorce; Barb does not.

Bargaining Bargaining and the Coase Theorem (2 of 4) If they live in a state that requires only one person to seek a divorce, who has the bargaining power? Can Adam be persuaded to stay married?

Bargaining Bargaining and the Coase Theorem (3 of 4) If they live in a state that requires two people to seek a divorce, who has the bargaining power? Can Barb be persuaded to divorce?

Bargaining Bargaining and the Coase Theorem (4 of 4) Exhibit 17.5 The Coase Theorem in Action Case Outcome Divorce requires consent of both partners The partner who values divorce at $5,000 (Adam) is not willing to pay the partner who values marriage at $10,000 (Barb) enough to buy the divorce. Result: No divorce. one partner The partner who values marriage at $10,000 (Barb) pays the partner who does not (Adam) an amount above $5,000 and below $10,000.

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