Auctions and Technology Enabled Pricing Strategies By Ravi Aron

Road Map Market Mechanisms Market Mechanisms  Auctions  Auctions and Pricing Risks  Auction structure and types  Market Outcomes in auction markets   Q&A

Going …Going …Gone! On the auctioneer’s block now … On the auctioneer’s block now …  Picture of the first dimpled ballot to be hand counted  A Chad Collection from Palm Beach county ballot Chad …and recently auctioned …and recently auctioned  Human Kidneys  Fake paintings  Dot-Com shares … Some items at that are being e-auctioned these days

Auctions Why Auction Products? Why not simply declare a price and let the buyers buy the product? Why Auction Products? Why not simply declare a price and let the buyers buy the product? Consider this simple problem - MicroEcon 101 revisited. Consider this simple problem - MicroEcon 101 revisited.  Say, I am the seller of a new Digital device.  Buyers’ willingness to pay for my product is unknown.  How should I price it? I Can’t determine the price. I Can’t determine the price.  Fortunately, I don’t have to …  … If I can determine which how different buyers value the product. An auction helps the seller estimate the structure of demand for her product. An auction helps the seller estimate the structure of demand for her product.

Product’s Value A basic reason for auctions is Information Asymmetry. A basic reason for auctions is Information Asymmetry.  The value of a product to a buyer is known only to that buyer Not all buyers may agree on a product’s value. Not all buyers may agree on a product’s value. There are two kinds of auctions – representing two different ways in buyers value products. There are two kinds of auctions – representing two different ways in buyers value products.  Buyers may value a product differently for different reasons.  Egyptian thimbles  Victorian Snuff boxes … These auctions are called Private Value auctions. These auctions are called Private Value auctions.

Common Value(s) Auctions The actual value of (any known measure of) the good is the same for all buyers. The actual value of (any known measure of) the good is the same for all buyers. However, buyers start with different estimates or private information about the following aspects of the good: However, buyers start with different estimates or private information about the following aspects of the good:  Quality of the good  Remaining Economic life of the good  Some ‘measure’ of the good Oil lease: Buyers disagree on how much oil can be extracted. Oil lease: Buyers disagree on how much oil can be extracted. Quality: Used machinery (DoveBid.com) Quality: Used machinery (DoveBid.com) Broadcast Spectrum: Number of potential subscribers Broadcast Spectrum: Number of potential subscribers

Common and Private Value Auctions In a Common Value auction, buyers can get meaningful information about product’s “true value” from other buyers’ bids. In a Common Value auction, buyers can get meaningful information about product’s “true value” from other buyers’ bids. In Private value auctions buyers rarely get any information about the product’s “true value” from other buyers. In Private value auctions buyers rarely get any information about the product’s “true value” from other buyers. There is a strategic reason for the existence of auction markets in the B2B context. There is a strategic reason for the existence of auction markets in the B2B context. This has to do with the mechanics of auction markets. This has to do with the mechanics of auction markets.

Structure of an Auction Two factors determine auction market outcomes: Two factors determine auction market outcomes:  Form in which bids are made  The sequence rules for bidding Let us look at four basic types Let us look at four basic types The ascending bid auction (English Auction) The ascending bid auction (English Auction)  Open, calling of bids.  Usually Oral, now electronic.  Bidders drop out one by one and the one remaining bidder wins.  Most often used in B2C and C2C.

Descending Bid Auctions Descending Bid Auctions (Dutch Auctions) Descending Bid Auctions (Dutch Auctions)  Price call opens at a price that is usually set at a very high value (that nobody would pay).  As the bid is continually lowered, buyers may either call out their bids or lose to a higher bidder (earlier bidder).  Usually exactly one bid which wins.  Can be used to great advantage under certain conditions by B2B suppliers (we will soon see what those conditions are).

Sealed Bidding First Price Sealed Bid Auctions First Price Sealed Bid Auctions  Each bidder independently submits a single sealed bid and the highest bidder wins.  Technically equivalent to the Dutch Auction.  Used in B2B Auctions (not necessarily electronic). Second Price sealed bid auction Second Price sealed bid auction  Winner pays the bid value of the highest losing bid *.  Vickrey Auction.  In private value auctions, this is equivalent to the Ascending Bid Auction.

Auction Taxonomy Auction Type Open Bidding Sealed Bidding AscendingEnglish First Price DescendingDutch Second Price Vickrey

View from the Economist’s Room All four types of auctions have the same revenue potential from the seller’s point of view. All four types of auctions have the same revenue potential from the seller’s point of view. In reality, what drives the relative distribution of benefits is the type of the auction and the extent of risk experienced by the buyer. In reality, what drives the relative distribution of benefits is the type of the auction and the extent of risk experienced by the buyer. Sealed bid auctions, especially for high priced items, tend to favor sellers. Sealed bid auctions, especially for high priced items, tend to favor sellers.  Ariba, Commerce One and many other enablers let the market operator choose the type of market mechanism that favors him.

Online and Off Line - What Auction Models Operate? Ascending Bid: Antiques, Artwork, some real estate on eBay was sold recently using this method – C2C, B2C, B2B. Ascending Bid: Antiques, Artwork, some real estate on eBay was sold recently using this method – C2C, B2C, B2B. Descending Bid: Dutch flower auctions, Commodity procurement, eProcurement. Descending Bid: Dutch flower auctions, Commodity procurement, eProcurement. First Price Sealed Bid: sometimes used in B2B procurement, mineral rights, real estate Software Project Development contracts, etc. First Price Sealed Bid: sometimes used in B2B procurement, mineral rights, real estate Software Project Development contracts, etc. Second Price Sealed Bid: Not a frequently seen beast - stamps auctioned by mail. Second Price Sealed Bid: Not a frequently seen beast - stamps auctioned by mail.

Other Kinds of Auctions Reverse Auction: Reverse Auction:  Sellers bid for a buyers’ business.  The seller that makes the lowest bid (i.e., lowest price) – wins the auction.  Reverse Auctions too can be run by open or sealed bidding. Just as there are open and sealed bid auctions in the ‘regular’ auction format – there are open and sealed bid formats in reverse auctions too. Just as there are open and sealed bid auctions in the ‘regular’ auction format – there are open and sealed bid formats in reverse auctions too. There are ascending and descending bid formats in reverse auctions too. There are ascending and descending bid formats in reverse auctions too.

‘Regular’Auctions Reverse Auctions English Open, Ascending. Highest bid wins Open, bids go down – lowest bid wins. Dutch Open, price falls and the highest bid wins Open price rises and highest bid wins Sealed Bid First Price Sealed highest bidder wins Sealed lowest bidder wins Vickrey Highest bidder wins and pays the next bidder’s bid Lowest bidder wins and receives the next bidder’s bid

Multi-Quantity Auctions Suppose there is more than one product being auctioned and there are several bidders. How should the auctioneer set the rules? Suppose there is more than one product being auctioned and there are several bidders. How should the auctioneer set the rules? There are two basic kinds of auctions: There are two basic kinds of auctions:  Discriminatory  Non-discriminatory The key distinguishing factor is this: The key distinguishing factor is this: Do all buyers pay the same price? (Non- Discriminatory) Do all buyers pay the same price? (Non- Discriminatory) Does each buyer pay her bid ? (different prices and therefore discriminatory). Does each buyer pay her bid ? (different prices and therefore discriminatory).

Bid Versus Price Non-Discriminatory: Two flavors: Non-Discriminatory: Two flavors:  All Winners pay the lowest winning bid  [20,18,16.5, 15.75, 15.0, 14.5, 13.75, 12.5, 12.5, 11.0]  All winners pay the highest losing bid  [20,18,16.5, 15.75, 15.0, 14.5, 13.75, 12.5, 12.5, 11.0] Discriminatory Auctions: Discriminatory Auctions:  [20,18,16.5, 15.75, 15.0, 14.5, 13.75, 12.5, 12.5, 11.0]  [14.75,13.75,12.9,12.5,12.0,11.5,10.75,10,9.5,9.0,8.75] What is the optimal strategy for the bidder? What is the optimal strategy for the bidder?

Bidder Behavior and Strategic Implications Does the choice of auction format impact the outcome? Does the choice of auction format impact the outcome? Does bidders’ response to certain kinds of uncertainty result in frenzied over bidding? Does bidders’ response to certain kinds of uncertainty result in frenzied over bidding? Do Reverse Auctions bring about results that are very different from the regular auctions? Do Reverse Auctions bring about results that are very different from the regular auctions?

The Winner’s Curse: A Problem of Overly Aggressive Bidding

A Variety of Problems When different goods are sold on a Dutch auction – there are two kinds of uncertainties that bidders experience: When different goods are sold on a Dutch auction – there are two kinds of uncertainties that bidders experience:  Which product will competitors select if they win the auction?  How many units will they (competitors) specify when they place a winning bid? We sold three items in a Dutch Auction and then sold them separately in an English Auction one after another. We sold three items in a Dutch Auction and then sold them separately in an English Auction one after another. The results follow. The results follow.

Dutch – Uncertainty Amplifies Winner’s Curse

Dutch – Vs. English

Strategic Use of Multi-Round Auctions Select a subset of the most aggressive bidders from a group of bidders and hold a sub-auction between them. Select a subset of the most aggressive bidders from a group of bidders and hold a sub-auction between them. Will this produce price outcomes different from holding a single auction? Will this produce price outcomes different from holding a single auction? How are Reverse Auctions impacted by this phenomenon? How are Reverse Auctions impacted by this phenomenon?

Multi-Round Auctions

Multi-Round Reverse Auctions

Issues in the design of Industrial Auctions -1 Signaling in Ascending Price Auctions Signaling in Ascending Price Auctions Two blocks of Auction Spectrums (spectra?) being auctioned. Two blocks of Auction Spectrums (spectra?) being auctioned. Blocks 1-5 Blocks 5-10 Firm A million 20 million Firm B 20 million 12 million

Ascending Auctions: Punishment Strategy Ascending Auctions: Punishment Strategy Issues in the design of Industrial Auctions -2RochesterIowa US West 290,0000 McLeod300,00060, ,37862,378 McLeod062,000

Buyer Run Auction Markets MRO Goods Manufacturing Inputs Spot Sourcing Maximum Gains Maximum Gains suppliers will attempt to aggregate. suppliers will attempt to aggregate. Presence of a few large buyers can easily neutralize seller aggregation. Presence of a few large buyers can easily neutralize seller aggregation. Reverse Auction. Reverse Auction. Buyers can create switching costs to lock in suppliers. Buyers can create switching costs to lock in suppliers. Buyers’ supply risk can help suppliers protect profits. Buyers’ supply risk can help suppliers protect profits. Sealed Bid – Reverse Auction. Sealed Bid – Reverse Auction. Systematic Outsourcing Buyers’ power diminishes as level of customization increases. Buyers’ power diminishes as level of customization increases. Order fulfillment complexity offers suppliers opportunity to customize – “Deep Linking”. Order fulfillment complexity offers suppliers opportunity to customize – “Deep Linking”. Reverse Auction for long term supply contracts – followed by stable prices. Reverse Auction for long term supply contracts – followed by stable prices. Suppliers are strong. Suppliers are strong. Buyer focus will be on mitigating supply risks. Buyer focus will be on mitigating supply risks. Buyers’ power decreases with increase in product complexity and specificity. Buyers’ power decreases with increase in product complexity and specificity.

Supplier Run Auction Markets Objective: Set up a bidding war between buyers. Objective: Set up a bidding war between buyers. Factors that determine outcome Factors that determine outcome  Supply Risks faced by buyers  Extent of buyer fragmentation  Asset specificity and extent of customization required  Presence of Reverse Aggregators

Supplier Run Auction Markets MRO Goods Manufacturing Inputs Spot Sourcing Buyers are very strong. Buyers are very strong. Presence of Spot Markets can weaken seller’s pricing power. Presence of Spot Markets can weaken seller’s pricing power. Suppliers will prefer to set up ascending auctions / first price sealed bid auction. Suppliers will prefer to set up ascending auctions / first price sealed bid auction. Buyers’ supply Risks may determine extent of seller gains. Buyers’ supply Risks may determine extent of seller gains. Descending Bid Auctions. Descending Bid Auctions. Systematic Outsourcing Suppliers’ pricing power increases with extent of customization. Suppliers’ pricing power increases with extent of customization. Suppliers will attempt to erect entry barriers for other suppliers. Suppliers will attempt to erect entry barriers for other suppliers. Production capacity constraints may be the chief reason for auctions. Production capacity constraints may be the chief reason for auctions. Large, monopolistic suppliers will gain disproportionate revenue. Large, monopolistic suppliers will gain disproportionate revenue. Suppliers’ gain increases with increase in product complexity and specificity. Suppliers’ gain increases with increase in product complexity and specificity. Buyer focus will be on mitigating supply risks. Buyer focus will be on mitigating supply risks. Descending bid / First Price Sealed Bid auctions for long term contracts – or multi-tier auctions. Descending bid / First Price Sealed Bid auctions for long term contracts – or multi-tier auctions.

A Summary of Auctions in B2B Markets MRO Goods Manufacturing Inputs Spot Sourcing Buyers are relatively strongest. Buyers are relatively strongest. Reverse Auctions – Sealed Bid favor buyers. Reverse Auctions – Sealed Bid favor buyers. Limits to the effectiveness of Forward Aggregators. Limits to the effectiveness of Forward Aggregators. Buyers stand to gain more than suppliers. Buyers stand to gain more than suppliers. Buyers  Reverse Auctions Suppliers  Descending Bid Auctions / Multi-tier English Auctions. Buyers  Reverse Auctions Suppliers  Descending Bid Auctions / Multi-tier English Auctions. Extent of supply volatility may determine buyer / seller gains. Extent of supply volatility may determine buyer / seller gains. Systematic Outsourcing Suppliers’ pricing power increases with extent of customization. Suppliers’ pricing power increases with extent of customization. Sealed bid reverse auctions for longer term contracts favors buyers. Sealed bid reverse auctions for longer term contracts favors buyers. Opportunity for Forward Aggregators. Opportunity for Forward Aggregators. Suppliers’ pricing power is greatest. Suppliers’ pricing power is greatest. Descending Bid auctions. Descending Bid auctions. Product Specificity and Customization determine seller gains. Product Specificity and Customization determine seller gains. Opportunity for Reverse Aggregators. Opportunity for Reverse Aggregators.

Summary of Auction Mechanisms Two types of Auction Contexts Two types of Auction Contexts  Private Value  Common Value Auction Markets Dynamics Auction Markets Dynamics  Bidding Rules: Open Vs. Closed  Sequencing Rules: Ascending Vs. Descending Why do Auction markets exist? Why do Auction markets exist?  Information Asymmetry  Strategic Reasons (B2B markets). Reverse Auctions Reverse Auctions Discriminatory & Non-Discriminatory auctions Discriminatory & Non-Discriminatory auctions