Introduction Competitive Bidding

Session 2 - Introductions to competitive bidding

• Auctions often come together with negotiations
• Biddings are used to gain a shortlist of buyers first, afterwards make an auction amongst them
• HERE: company organizes auction to sell something (seller)

Bidding for a dollar: very efficient auction

• Difficulties: Risk aversion? Make sure you get a payoff while trying to secure a win?
• More competition -> higher bid, to make a sufficient chance of winning
• Don’t need many bidders for the final price to be close to $1 -> 3-5 ppl. In this example
• Efficient when we don’t need many bidders for the seller to extract maximum gain from the buyers

Ideal (“vanilla”) conditions:

1) Valuation scenario: common value 

• Independent private values (IPV) → subjective, bidders have different preferences, values
• Common Value → objective, same preferences, values (“winning equally valuable to everybody” does not mean that when all bidders have to bid, they all have the same estimate/expectations of the true market value / market conditions that prevail when finally the winning bidder has the opportunity to resell)

2) Information scenario: Total transparency 

Different conditions for different auction types to use:

• Assumptions for optimal strategies:

• IPV
• V (I), V(2), V(3),..= maximum price bidder 1 / 2 / 3 would be willing to pay (bidder 1 = highest).

• English auction: open, bidding are successively raised until one bidder remains. (price=last bid). Used for art, antiques. At any moment in time you see what the others are bidding and have the opportunity to adjust bid accordingly

• Optimal bidding behavior:  

• When to stop: when everybody stops / our valuation (reservation price)
• Increments: smallest allowed increment (avoid overshooting, i.e. pay more than necessary to get the item than necessary to get it). when bidding against professionals, well-informed, rational and hard-to-scare people avoid jumps to avoid overshooting  
• When to start: start late to avoid other people revising their valuation (if you have superior information, you try to defeat the purpose of an English auction); ask someone to bid on your behalf (if you are a specialist) or be as inconspicuous as possible (phone, Internet) and only start bidding when you really have to do so to avoid create momentum in the auction and don’t miss out an opportunity

• Expected price: V(2) (slighty higher, lower, equal)
• -> English auction may not be good when there is a big difference between V(1) and V(2)

• Dutch auction: converse to English. Auctioneer initially announces a high price and reduces price by the clock. Bidders can stop the auction by saying he wants to pay the price that was being announced at that moment. (Tulips are sold this way, Fish in Portugal..)

•  Optimal bidding behavior:

• Stopping point: Trade-off in Amount vs. Probability of winning; need assumptions about behavior of other bidders based on their past behavior (valuations, bidding behavior, risk aversion)

• Expected price: V(1) – “something”

• First-price sealed-bid auction: highest bid get item and pay price equal to his sealed bid. Used in procurement contracts to select among suppliers, real estate, artwork. you decide how much to bid, don’t have the opportunity to revise the bid.

• Optimal bidding behavior:

• How much to offer: Trade-off in Amount vs. Probability of winning

• Expected price: is “strategically equivalent” to the Dutch auction → same expected price V(1) – “something”
• If number of bidders is small, the winning bidder typically makes a large profit
• As the number of bidders increases, bids become closer to valuations (competition matters)
• Bids increase with the number of bidders, but at a diminishing rate

• Second-price sealed bid auction (vickrey auction): bidders submit sealed bids, but winner pays price equal to second highest bid. Ebay.

• Optimal bidding behavior: bid your valuation.  
• Expected price: v(2)

• Ebay “Tell us how much you are valuing the item and we will bid for you” -> stimulates participation, easy to bid for normal people

• How to choose among auction types?

• Criteria:

• Get information (for ex. if you will deal again with people in the future, gain information about valuation of bidders for the shortlist of highest bidders in the negotiation)
• -> second price sealed bid option (they get a demand curve of all bidders)
• Avoid buyer collusion

• -> NO INCENTIVE TO DEVIATE English Auction: collusive agreement is sustainable as retaliation is possible and deviation are not possible
• -> NO INCENTIVE TO DEVIATE First price sealed bid auction: CA may be submission (as bidders sometimes face each other again in future auctions)
• -> NO INCENTIVE TO DEVIATE Second price sealed bid auction: smart bidders refrain their preferred bidding agreement in such a way that the desired outcome is achieved. It should be sustainable. V(B) etc don’t have an incentive to deviate
• BEST: First price sealed bid auction, Dutch Auction

• Minimize transaction costs -> Open auctions that maximize speed and convenience such as Dutch Auction, English Auction. (nowadays less important due to technological advances, except for perishable goods like flowers/fish)
• Efficient allocation (in government auctions as the government wants to give the item to the bidder who is able to extract most economic value from the object -> social welfare, value for society, create more employment etc.) -> English auction as bidder has the chance to revise his bid
• Maximize expected price ->

• EP (EA) = EP (SBSBA) = V(2)
• EP(FBSBA) = EP(DA) = V(1) – “Something”
• Take advantage of situation to induce bidder with V(1) to bid close to his valuation ! Maybe V1 and V2 are far apart -> make bidder bid close to V1!

• “Benchmark case” assumptions: risk neutral bidders, independent-private-values scenario (subjective valuations), symmetric bidders (both bidder and auctioner are not able to tell which bidder has the highest valuation); payment as function of bids alone (no royalty / percentage of sales etc as it is not dependent on bids alone!); exogenous number of bidders (independent of which auction types we chose, number of bidders is the same)

• Revenue equivalence theorem: All auction lead to the same price on average, namely V(2) → these assumptions are necessary and sufficient conditions for the result to hold! If not, then an auction type is preferred over the other!
• Risk-averse bidders: Maximise the uncertainty the risk averse bidder is facing! –> FPSBA
• Correlated values: when our valuation has both a subjective component (IPV) and an objective market-oriented component (CV), for ex. a painting. -> by observing what other bidders bid (market bid), you may revise your estimate of the market value and hence your valuation. Allow valuations to converge (+increase transparency, more competitive, price goes up, closer to ideal scenario in perfect assumptions) -> English Auction
• Asymmetric bidders:

• A) Valuation asymmetry :

• Hide asymmetries → FPSBA
• Artificially enhance competitive pressure coming from non-competitive bidders -> discriminatory auction: handicap or favouritism (help V2 bidders to become more aggressive bidders to increase competitive pressure on V1)

• Information asymmetry → adverse selection. Bad for the seller, as unimformed players are afraid of losing and thus bid low, informed bidders then have no incentive to bid high.
• Solutions:

• Auction all drilling at the same time
• Play with the sequence
• Collect information and make it available to all bidders before the auction
• English auction (-threat of collusion)
• Royalty (percentage of revenues created) instead of lump-sum payment (decreasing the importance of information asymmetry; distortion as it decreases the incentive of oil companies to maximize their output volumne as marginal costs increase and thus the optimal output level of oil companies decrease)
• Winners curse: there is always a winner who overestimates the value of the object, he wins the game but loses money

• Driven by: common value, competition, uncertainty

• → if uncertainty is present, revise your bid accordingly!