1. Chapter 18: Auctions
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Managerial Economics: A Problem Solving Approach (2nd Edition)
Luke M. Froeb,
Brian T. McCann,
Website, managerialecon.blogspot.com
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Slides prepared by Lily Alberts for Professor Froeb

2. Summary of main points
In oral or English auctions, the highest bidder wins by outbidding the second- highest bidder. This means that the second-highest bidders’ value determines the price.
A Vickrey or second-price auction is a sealed-bid auction in which the high bidder wins but pays only the second- highest bid. These auctions are equivalent to oral auctions and are well suited for use on the Internet.
In a sealed-bid first-price auction, the high bidder wins and pays his value. Bidders must balance the benefits of bidding higher (a higher probability of winning) against the costs of bidding higher (reduced margin if they do win). Optimal bids are less than bidders’ private values.

3. Summary of main points (cont.)
Bidders can increase their profit by agreeing not to bid against one another. Such collusion or bid rigging is more likely to occur in open auctions and in small, frequent auctions. If collusion is suspected,
do not hold open auctions;
do not hold small and frequent auctions;
do not disclose information to bidders—do not announce who the winners are, who else may be bidding, or what the winning bids were.
In a common-value auction, bidders bid below their estimates to avoid the winner’s curse. Oral auctions return higher prices in common-value auctions because they release more information than sealed-bid auctions.

4. Introductory anecdote: Polaroid
In 1948, Polariod Corporation released its first instant camera, launching one of the most famous brand names of the twentieth century.
In the early 1990s, sales peaked at $3 million, but competition began to destroy the company’s advantage.
After bankruptcy trouble in 2001, the company was sold to Petters Worldwide Group in 2005 for $426 million.
Polariod made a short comeback but was put into bankruptcy after Petter’s was charged with an alleged $3.5 billion Ponzi scheme.
The court was unsure of the value of some of the company’s assets, such as the “Polariod” name, and decided to sell these assets with an auction.
The bidding started at $40 million but was pushed up to $75 million after successive rounds of bidding.

5. Introduction: Auctions
Auctions are simply another form of competition, like price competition or bargaining.
CarBargains is one company that uses auctions to help car buyers.
In these auctions, though, sellers not buyers are competing.
Local car dealers offer prices to a single consumer in a sealed- bid auction.
Auctions set a price and identify the high-value buyer or low- cost seller.
Auctions are often used in combination with bargaining, e.g., first an auction is used to identify the high-value buyers and then there is a negotiation over the final price.

6. Oral Auctions
Definition: In an oral or English auction, bidders submit increasing bids until only one bidder remains. The item is awarded to this last remaining bidder.
Example: Suppose there are five bidders with values equal to {$5, $4, $3, $2, $1}.
The $5 bidder will win the auction, and bids only slightly over $4 to do so.
The “price” or winning bid is $4, or slightly above.
The winning bidder is willing to pay $5 but doesn’t have to, so the losing bidders determine the price in oral auctions.
Auctions identify the high-value bidder (“efficiency”) and set a price for an item, with no negotiating necessary. For these reasons, economists love auctions.

7. Benefits of auctions Example: auction vs. posted-price
A retail store is unsure whether they should price high ($8) or low ($5) for a certain item.
If the store prices high, they sell to only high-value buyers (half the time). If the store prices low, they sell to all customers at a lower price.
If MC = $3, then pricing high is preferable
(.5)($8-$3) = $ [versus (1.0)($5-$3) = $2.00]
If the store uses an auction instead, and two bidders show up with values $8 and $5 – meaning there is again a .5 chance of selling to a high-value costumer – what will the revenue of the sale be?

8. Oral Auctions (cont.)
With two high-value bidders, the final price is $8. This outcome occurs only 25% of the time. The other 75% of the time, the second-highest value is just $5. The expected revenue of the auction is the weighted average of these two outcomes, (0.75)($5) þ (0.25)($8) ¼ $5.75. Compared to a fixed price of $8 with expected revenue of $4, the auction gives the seller higher expected revenue.
Proposition: More bidders raise the expected price of the auctioned item.
Again, with two or more high-value bidders the final price will be $8. But this happens only 50% of the time. The other 50% of the time, we expect at most one high-value bidder, so the winning bid is $5. Expected revenue is (0.5)($8) þ (0.5)($5) ¼ $6.50.
So, stronger losing bidders lead to higher winning bids.

9. Second-Price Auctions
Definition: A Vickrey or second-price auction is a sealed-bid auction in which the item is awarded to the highest bidder, but the winner pays only the second-highest bid.
This at first seems counterintuitive – why leave money on the table? But second-price auctions encourage bidders to bid more aggressively.
William Vickrey and James A. Mirrlees shared the Nobel Prize in Economics for their work inventing the Vickrey auction and establishing that there is no difference in outcome between an oral and second- price auction.

10. Second-price auctions (cont.)
Because the winning bidder pays the price of the second-highest bid, bidders are willing to bid up to their values, so the outcome is the same as an oral auction.
Second-price auctions are easier to run than oral auctions because the bidders can bid in remotely, and asychronously (at different places and times).
Discussion: Why are eBay auctions equivalent to second- price auctions?
Discussion: Why does eBay use second-price auctions?
eBay auctions are equivalent to second-price Because they employ “bidding agents” that automatically raise bids for you up to the amount of the second highest bid
The answer is that a second-price auction makes bidders bid more aggressively than a first-price auction

11. Sealed-Bid Auctions
Definition: In a sealed-bid first-price auction, the highest bidder gets the item at a price equal to the highest bid.
These auctions present a difficult trade-off for bidders:
A higher bid reduces the profit if you win, but
Also raises probability of winning
Bidders balance these two effects by bidding below their values (“shading”).
Experience and knowing the competing bidders are the keys to these auctions, but in general, bid more aggressively – shade less – if the competition is strong.

12. Bid Rigging or Collusion
Example: an oral auction with bidder values of {$5, $4, $3, $2, $1}.
Suppose that in this auction the two high-value bidders have formed a bidding ring (also known as a cartel).
The two decide NOT to bid against each other, so the cartel wins the item by outbidding the non-cartel members, i.e., price= $3. The cartel makes a profit of $1 which typically is split evenly between members.
Bid-rigging is a criminal violation of antitrust laws in the US and many other countries.
In one type of bid-rigging, cartel members re-auction the items won in a second-auction to cartel members in a second or “knockout” auction.

13. Bid-rigging / Collusion (cont.)
Another type of collusion is known as a bid-rotation scheme. This scheme uses quid pro quo bidding behavior.
Bidders in these cartels submit weak bids or refrain from bidding against each other until it is their turn to “win.”
In a bid-rotation scheme each cartel member must wait for his turn to win – a weakness that leaves these schemes vulnerable to cheating.
Proposition: Collusion is more likely in oral auctions.
Proposition: Collusion is more likely in small, frequent auctions.
In an oral auction, cartel can immediately determine defection and punish the defector, so collusion is easier to enforce. In a sealed-bid auction, collusion requires the cooperation of all the cartel members; that is, the cartel members must figure a way out of the prisoners’ dilemma.
Small, frequent auctions allow colluders to spread the “wins” around

14. Bid-rigging: Frozen Fish Conspiracy
After this cartel was broken the price of fish dropped 23%
Investigators backcast from the competition period into the collusive period to determine the cartel’s effect, i.e., what the price would have been, “but for” the conspiracy.

15. Reacting to bid-rigging
The government is frequently the victim of bid-rigging schemes.
Learning from the government’s experience, some tips to avoid collusion:
Do not rely on purchasing agents (those running the auction) who have little interest in buying at a low price. Instead, reward agents for making good (high-quality and low-price) purchases.
Do not entangle purchasing agents with masses of red tape. Instead, permit them to negotiate (e.g., to bargain with the bidders) if they suspect bid rigging.
But beware of patronage
Do not use the procurement process to further a social agenda (small business set-asides, public lands, national defense, etc.) that is irrelevant to the goal of purchasing goods at low prices.

16. Avoiding collusion (cont.)
Keep cartels in the dark, so it is difficult for them to organize and to punish cheaters.
do not hold open auctions;
do not hold small and frequent auctions;
do not disclose information to bidders—do not announce who the other bidders are, who the winners are, or what the winning bids are.

17. Common-Value Auctions
Definition: In a common-value auction, the value is the same for each bidder, but no one knows what it is. Each bidder has only an estimate of the value.
Be careful in these auctions lest you suffer the “winner’s curse”
If you win, you learn that you were the one who had the highest and most optimistic estimate of the unknown value of the item
Bidders should reduce their value estimates to protect against this.
If you are the auctioneer, release info to mitigate winners’ curse.
Winner’s curse is worse when
More bidders
Other bidders have better information
If there is a common-value component to the auction, rivals learn something about the item’s value by observing your bid, which creates an incentive to hide your bid. By submitting bids at the last minute, bidders can effectively hide their bids and turn what resembles an oral auction into a sealed-bid auction.

18. Common-Value Auctions (cont.)
To avoid the winner’s curse bid less aggressively as the number of bidders increases.
In common-value settings, oral auctions return higher prices than sealed-bid auctions because oral bids reveal information.
But oral auctions are more vulnerable to collusion.
Discussion: Why do bidders wait until the last minute of the auction to submit bids on eBay?
Because eBay has a common-value component, bidders wait to hide their information, by waiting until the last second of the auction to submit bids, called “sniping.” By submitting bids at the last second bidders can turn an oral auction into a sealed-bid auction. To combat this strategy, some auctioneers automatically extend the auction for five minutes following the receipt of a last-second bid.

19. Managerial Economics - Table of contents
1. Introduction: What this book is about
2. The one lesson of business
Benefits, costs and decisions
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
The problem of adverse selection
The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?
Managerial Economics - Table of contents