Auctions -- First-Price, Sealed Bid (Discriminatory)
-by Kate Reynolds
One in a Series of Articles from Agorics, Inc.The third auction type considered here has a primary characteristic of being sealed (not open-outcry like the English or Dutch varieties) and thus hidden from other bidders. A winning bidder pays exactly the amount he bid. Usually, (but not always) each participant is allowed one bid which means that bid preparation is especially important. To confuse matters the financial community refers to this type of auction as an English auction (except in Great Britain where it is known as the American auction!). In these articles we will use the academic name rather than that used in financial circles.
Speaking generally, a sealed-bid format has two distinct parts--a bidding period in which participants submit their bids, and a resolution phase in which the bids are opened and the winner determined (sometimes the winner is not announced).
An important distinction must be made as to quantity--how many goods are being auctioned--one or multiple items. The name "first-price" comes from the fact that the award is made at the highest offer when a single unit is sold. When multiple units are being auctioned, it is called "discriminatory" because not all winning bidders pay the same amount.
It works like this: In a first-price auction (one unit up for sale) each bidder submits one bid in ignorance of all other bids. The highest bidder wins and pays the amount he bid. In a "discriminatory (more than one unit for sale) auction", sealed bids are sorted from high to low, and items awarded at highest bid price until the supply is exhausted. The most important point to remember is that winning bidders can (and usually do) pay different prices.
From a bidder's point of view, a high bid raises the probability of winning but lowers the profit if the bidder is victorious. A good strategy is to shade a bid downward closer to market consensus, a strategy that also helps to avoid winner's curse.
This type of auction is used for refinancing credit and foreign exchange. Up until 1993, the U.S. Treasury used the discriminatory auction to sell off its debt, but this method is not without its detractors. In the case of U.S. Treasury securities, Milton Friedman warned early on that the discriminatory auction was susceptible to collusion. An investor is reluctant to expose his valuation to the Treasury because the stated intention of the Treasury is to gain the highest price possible. It is advantageous to a bidder to gather information about a competitor's valuation before the auction. Milton Friedman proved to be prophetic. The U.S. Treasury securities auction will be discussed later in greater detail.
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