1. 1 Teck-Hua Ho April 18, 2006 Auction Design I. Economic and Behavioral Foundations of Pricing II. Innovative Pricing Concepts and Tools III. Internet Pricing Models

2. 2 Teck-Hua Ho April 18, 2006 Outline  Choice of Price Format  Auction Formats  Strategic and Revenue Equivalence  A Field Test  An In-Class Experiment on Common-Value Auction

3. 3 Teck-Hua Ho April 18, 2006 Choice of Price Format Seller Buyer Seller & Buyer Price Setting Party Price Over Time / Price Formation Static Dynamic www.priceline.com www.landsend.com www.freemarkets.com www.ebay.com www.letsbuyit.com Financial markets www.amazon.com

4. 4 Teck-Hua Ho April 18, 2006 Observations  Buyer versus seller:  Ample (limited and unique) supply  Seller (buyer) set prices  High (low) knowledge of buyer WTPs  Seller (buyer) set prices  Static versus Dynamic  High (low) product perishability  Dynamic (static) pricing models  Price fairness is (not) an issue  Static (dynamic) pricing models  High information asymmetry between buyers and sellers  Dynamic pricing (auction)  Higher efficiency  Dynamic pricing

5. 5 Teck-Hua Ho April 18, 2006 Design of Auction Price Setting Party Seller Buyer Seller & Buyer Price Over Time Static Dynamic - Dutch - English - 1 st Price Sealed-bid - 2 nd Price Sealed-bid

6. 6 Teck-Hua Ho April 18, 2006 Promises of Internet Auction  Increased convenience (temporal, geographical)  Asynchronous bidding is possible  Larger markets for the seller  Increased ability to search (for the buyer)  Removes the need to choose a price for a product

7. 7 Teck-Hua Ho April 18, 2006 Design of Auction: Auction Formats  Dutch auction (D) (e.g, www.landsend.com; http://www.vbn.nl/en/overvbn/index.asp ) www.landsend.com http://www.vbn.nl/en/overvbn/index.asp  First-price sealed-bid auction (F) (e.g., US Treasury bills, supply contracts; government procurement (10% GDP))  Second-price sealed-bid (Vickrey) auction (S) (e.g., www.sandafayre.com; NZ’s communication spectrum rights) www.sandafayre.com  English auction (E) (e.g., www.ebay.com ; www.yahoo.com )www.ebay.com www.yahoo.com

8. 8 Teck-Hua Ho April 18, 2006 Two Fundamental Questions  Which auction pairs are strategically equivalent?  Types A and B are strategically equivalent if an identical bidder would follow the same strategy  Which auction pairs are revenue equivalent?  Types A and B are revenue equivalent if they yield the same expected revenue

9. 9 Teck-Hua Ho April 18, 2006 William Vickrey WILLIAM VICKREY 1996 Nobel Laureate in Economics for fundamental contributions to the economic theory of incentives under asymmetric information.

10. 10 Teck-Hua Ho April 18, 2006 Independent Private-Value Auction  Buyers are risk-neutral  Buyers WTPs are independent of each other and drawn from a uniform distribution  What will be the optimal bidding strategies in the following auction formats:  Open English auction?  Second-price sealed bid (or the so-called Vickrey auction)?

11. 11 Teck-Hua Ho April 18, 2006 Strategic Equivalence Theorem  Buyers’ bidding strategies are identical in open English and second-price sealed-bid auction (except for the winner)  Second-price sealed bid auction  Optimal bid for all bidders =  English auction  Optimal bid for all bidders except the winner =  Optimal bid for the winner =  Revenue =  Buyers’ bidding strategies are identical in Dutch and first-price sealed-bid auction  Optimal bid for bidder i =  Revenue =

12. 12 Teck-Hua Ho April 18, 2006 Expected K th Highest Value  Let buyer WTPs (independently drawn from an uniform distribution) are denoted by WTP 1, WTP 2, …, WTP n-1, WTP n  Arrange them in an ascending order and denote ranked bids by WTP (1), WTP (2), …, WTP (n-1), WTP (n). That is, we have WTP (1) < WTP (2) < …< WTP (n-1) < WTP (n)  Expected K th Highest Value:

13. 13 Teck-Hua Ho April 18, 2006 Revenue Equivalence Theorem  Expected revenue is identical in open English and second-price sealed-bid auctions  Expected Revenue =  Expected revenue is identical in Dutch and first-price sealed-bid auctions  Expected Revenue =  Expected revenue is identical in Dutch, English, first-price, and second-price sealed-bid auctions  IPV  Rational, risk-neutral bidders

14. 14 Teck-Hua Ho April 18, 2006 What Happen When Assumptions Fail? ModelRevenue Rankings IPV and risk neutralityD = F = S = E IPV & risk aversionD = F > S = E Affiliated privately known WTPs and risk neutrality D = F < S = E Affiliated, privately unknown WTPs and risk neutrality D = F < S < E Privately unknown values are those where a bidder is uncertain about his own WTP until the auction is over, although he or she does have some noisy signal of his or her WTP

15. 15 Teck-Hua Ho April 18, 2006 Why Does Ebay Choose English Auction?  In low-priced items, bidders are likely to be risk neutral  In these cases, English auction has the highest expected seller revenue  Note that Ebay’s revenue increases with seller revenue  Thus, the choice of English auction is consistent with revenue maximization for Ebay

16. 16 Teck-Hua Ho April 18, 2006 A Field Test  Are Dutch and First-Price sealed-bid auctions “revenue equivalent?”  What might this imply for internet auction design?  Are English and Second-Price auctions “revenue equivalent?”  What might this imply for internet auction design?

17. 17 Teck-Hua Ho April 18, 2006 Dutch versus First Price Auction First - DutchDutch - First Number of Observations 8786 Dutch higher6359 Equal revenue125 First-price higher1222 Mean Dutch-First price difference $0.38$0.25

18. 18 Teck-Hua Ho April 18, 2006 English versus Second- price Auction English - SecondSecond - English Number of Observations 6698 English higher2065 Equal revenue89 Second-price higher 3824 Mean English- Second price difference -$0.09$0.85

19. 19 Teck-Hua Ho April 18, 2006 Internet Auction Sites  Types of products  Products in limited supply  Instances where demand is unknown to the seller  Types of revenue model  80% appear to be “listing sites,” most others “merchant sites”  Types of auction format  85% English auction, 14% first-price sealed bid, 1% Dutch  Why second-price sealed auction (Vickrey) is uncommon?

20. 20 Teck-Hua Ho April 18, 2006 Common-Value Auctions  So far, we analyze only private-value auctions  In many industrial settings, firms engage in the so- called common value auctions (e.g., oil leases, resellers)  Ex ante, bidders have different guesses about how much the item is objectively worth  Ex post, all bidders have the same ex post valuation for the good

21. 21 Teck-Hua Ho April 18, 2006 In-Class Experiment on Common-Value Auction  In-class bidding for a jar of coins  Write down your name  Provide an estimate for its worth  Submit a bid for the item  First-price sealed-bid auction: Highest bidder wins and pays what he/she bids  A prize of $10 for the person who has the most accurate estimate

22. 22 Teck-Hua Ho April 18, 2006  Name:__________________________  Estimate: __________________________  Bid:__________________________ Your Response on Index Card

23. 23 Teck-Hua Ho April 18, 2006 Winner’s Curse  Winner’s curse occurs when the winner’s bid is higher than the true value of the object. Winning the bid but lose money!  Robust phenomenon; occurs frequently both in experiments and in real life  Optimal Bidding Strategy  The less information you have compared with that your opponents have, the lower your bid ought to be  The more uncertain about the true value, the lower you should bid  The more bidders that show up for the auction, the lower you should bid

24. 24 Teck-Hua Ho April 18, 2006 Punchline  Strategic and revenue equivalence theorems  English is the most prevalent in internet auctions  English auction induces truthful revelation of WTPs (i.e., Revelation Principle)  English auction gives the highest expected revenue when bidders are risk neutral  Beware of winner’s curse in common-value auction!