By Kelvin Tai - Economics and Management Student @ Harris Manchester College, Oxford
You may be most familiar with English auctions, often portrayed in popular media where bidders shout out increasing bids until the auctioneer completes his “going once, going twice, gone” routine. One can see how the price may vary based on the willingness to pay. However, there are many variants of auctions.
One type is the Dutch auction. Instead of increasing bids, the Dutch auction works by having a high asking price and the auctioneer decreasing the amount until someone bids for it. It’s not difficult to see why this could extract more consumer surplus than the English version. Assume an auction with 2 people, where person A is willing to pay $10 and person B $50. Both do not know each other’s willingness to pay. An English auction would probably end with Person B winning the bid with $11 after person A calls for $10, and person A would hence refrain from a further bid. In contrast, a Dutch auction would result in person B bidding at $50, since A’s willingness to pay is unknown to B.
Other auction types are known as closed envelope bids. This is often used for government contracts, where private contractors put their bids into sealed envelopes and submit them simultaneously. The lowest bid hence wins the contract. Some prefer a variant known as the Vickrey auction, where the best bid is chosen but the contract is given at the rate of the second best bid.
This may seem counter-intuitive, since the government is paying more than the lowest bid. It can in fact be advantageous though. Imagine again a situation where contractor A can do the work at $400 and contractor B can do it at $350. In the sealed envelope situation, A will probably bid for $500, to make a profit of $100, while B would bid at $450. B would hence win. However, in the Vickrey auction, B would bid $350, while A would bid at $400, since both are confident that if their bid is the lowest, they would be awarded the higher amount of the other party and can hence turn a profit. If they bid higher than their cost price, they have a lower chance of winning the contract. If they bid lower than their cost, they might risk having to do the job at a loss if the other party bids an amount between their bid and the cost. Hence, they will always bid their cost and the government pays out the cost of the second lowest bidder.
Vickrey auctions are susceptible to collusion (contractors may agree on what to bid, so the pre-agreed loser bids a high amount to give the contractor a higher sum and they split the profits). As such, these auctions should only be conducted when there are a large number of contractors and there is a low probability that they will all be able to collude.
Auctions are involved in the business models of numerous firms, ranging from auctions on eBay to Google’s auction for keywords. How they are structured and the incentives of the participating economic agents can have massive implications on the distribution of economic benefit.
Further reading:
Alfnes, Frode. "Willingness to Pay versus Expected Consumption Value in Vickrey Auctions for New Experience Goods." American Journal of Agricultural Economics 89.4 (2007): 921-31. Web.
Robinson, Mary, and Robinson, Richard. "Dutch-auction IPOs: Institutional Development and Underpricing Performance." Journal of Economics and Finance 36.3 (2012): 521-54. Web.
Aggarwal, Gagan, Muthukrishnan, S., Pal, David, and Pal, Martin. "General Auction Mechanism for Search Advertising." (2008). Web.