Going ... Going ... Gone!

-by Kate Reynolds

One in a Series of Articles from Agorics, Inc.

More to the point, why does it matter? Perhaps because auctions are a multi-billion dollar business, and the mortgage rate you pay is determined in part by auctions held by the U.S. Treasury. Perhaps because that particular auction is not the kind of auction you think it is. Perhaps because some bidders spend years mastering strategies that enable them to exploit the misunderstandings of the unwary. And perhaps because smart auction principles can be used to buy and sell computer resources in a way that substantially optimizes human time and money. However, before all that, what exactly is an auction?

Even the term auction (root, "auctio", means increase) is a misnomer because not all auctions have ascending price schemes. In fact, there are many different auction formats including the familiar ascending bid, but also including the descending, sealed-bid, simultaneous, handshake, and whispered forms of bidding. Many of the more unusual formats have been practiced for hundreds of years including one variety in which huge estates have been sold during the time it took for a single one-inch candle stub to flicker out.

Auctions are useful when selling a commodity of undetermined quality. Banks compete for loan customers of uncertain risk, graduate schools compete for students of unknown ability, [Vincent] wine merchants may not have tasted the wares. Auctions can be used for single items such as a work of art and for multiple units of a homogeneous item such as gold or Treasury securities. For countries changing from centrally-planned to market-based economies, auctions offer an ability to value goods that might not otherwise be available. They are useful in circumstances wherein the goods do not have a fixed or determined market value, in other words, when a seller is unsure of the price he can get.

Choosing to sell an item by auctioning it off is more flexible than setting a fixed price and less time-consuming and expensive than negotiating a price (such as happens in a car lot). In a price negotiation, each bid and counter-bid is considered separately, but in an auction the competing bids are offered almost simultaneously.

In fact, an auctionable resource can be nearly anything--public land, livestock, wine, flowers, fish, cars, construction contracts, equity shares, or contracts in the game of bridge. The common denominator is that the value of each item varies enough to preclude direct and absolute pricing. In one fascinating experiment, external offices (with prized windows and locations) were auctioned off as a way of solving the quandary of how to allocate physical resources at Arizona State University's College of Business without infuriating the entire staff. [Boyes]

Simply stated, an auction is a method of allocating scarce goods, a method that is based upon competition. It is the purest of markets: a seller wishes to obtain as much money as possible, and a buyer wants to pay as little as necessary. An auction offers the advantage of simplicity in determining market-based prices. It is efficient in the sense that an auction usually ensures that resources accrue to those who value them most highly and ensures also that sellers receive the collective assessment of the value. (In later chapters, we will see that sellers do not necessarily receive maximum value in the ascending-bid format. [Varian]) What is unique about the auction is that the price is set not by the seller, but by the bidders.

On the other hand, it is the seller who sets the rules by choosing the type of auction to be used.

One oddity regularly occurs in the wine auction market. [Ashenfelter] It is commonly understood in wine circles that when identical lots of wine are peddled at the same auction, later lots are frequently sold for a lower price than early lots. Auctioneers know this but are reluctant to reveal this information to inexperienced participants because such bidders often conclude that the auction house is dishonest. Thus, auctioneers have learned to disguise this anomaly by offering small lots of wine A before offering larger lots of wine A. People assume the reason for the price difference comes from a quantity discount, and so they pay no attention. In fact, the difference is real.

An auction is unusual also in that, unlike other methods of selling, generally the auctioneer doesn't own the goods, but acts rather, as an agent for someone who does. Frequently, the buyers know more than the seller about the value of the item. A seller, not wanting to suggest a price first out of fear that his ignorance will prove costly, holds an auction to extract information he might not otherwise realize.

There are different ways to classify auctions. There are open auctions as well as sealed-bid auctions. There are auctions where the price ascends and auctions where the price drops at regular intervals. Generally, experts agree that there are four major one-sided auction formats: English, Dutch, First-Price sealed-bid, and Vickrey (uniform second-price). One difficulty is the lack of commonality in naming conventions. What some people call a uniform second-price auction is known in financial communities as a Dutch auction, and no end of confusion results.

Which auction is best? The answer depends upon many variables. A seller's perspective is different from that of a buyer. Some auctions types decrease the incentives to cheat while others provide ample room for mischief. Sometimes speed is important. If you are selling flowers or fresh fish or anything that has to get to market quickly, an auction that takes weeks or even hours is not a good solution. In some auctions the buyer must be present, and that is sub-optimal if the auction is in New York and you are in Tokyo. Different circumstances dictate different answers.

Sometimes an auction is useful in hindering dishonest dealings. If the mayor of New York were free to accept the first bid made by a contractor on a new city building, the contractor would probably be a relative and the taxpayers would lose money (again).

Are there drawbacks to auctions? Of course. "Winners curse" is widely recognized as being that phenomenon when a "lucky" winner pays more for an item than it is worth. Auction winners are faced with the sudden realization that their valuation of an object is higher than that of anyone else.

In auctions in which no bidder is sure of the worth of the good being auctioned, the winner is the bidder who made the highest guess. If bidders have reasonable information about the worth of the item, then the average of all the guesses is likely to be correct. The winner, however, offered the bid furthest from the actual value. [Thaler] (Actually, winner's curse is everywhere in subtle forms. Do you really want to hire the employee who has been passed over by other employers? Do you want to be the publisher who buys a manuscript that other editors have rejected?)

All in all, the auction, though not always as simple as it appears, can be thought of as a pure marketplace at work in its finest form.

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