Essay: Auctions

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  • Subject area(s): Economics essays
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  • Published on: January 13, 2020
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  • Auctions
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WHAT IS AUCTION?

An auction is a method of purchasing and selling of goods or services by offering them up for bid, taking bids, and then selling the item to the highest bidder.

TYPES OF AUCTIONS.

• English auction: mostly referred to as “open ascending price auction’’ is a type of auction that is the most common system of auction used today. In this type of auction, contestants bid openly against one another, with each ensuing bid required to be greater than the previous bid. The process is done either by an auctioneer announcing prices or bidders call out bids by themselves or even submitted electronically with the highest current bid publically displayed. The auction ends when there is no bidder willing to pay a higher price. The most significant difference about this type of auction is that the present highest bid is at all times available to anybody that is willing to make a counter bid. The English auction is commonly used for selling goods, real estate, antiques and artwork.

• Dutch auction: mostly referred to as the ‘’ open descending price auction’’. In the traditional Dutch auction the auctioneer starts by asking a high price for some quantity of identical products; the price is dropped until a bidder is ready to accept the auctioneer’s price for the goods in the lot or until the seller’s reserve price is met. If the first bidder does not obtain the whole lot, the auctioneer continues lowering the price until all of the items have been bid for or the reserve price is reached. Items are distributed based on bid order; where the highest bidder will choose their item(s) first followed by the second highest bidder, etc… Eventually, all of the winning participants pay only the last announced price for the items that they bid on. The Dutch auction was named after, the Dutch tulip auctions. (“Dutch auction” is also sometimes used for online auctions where a number of identical merchandises are sold instantaneously to an equal number of high bidders. Dutch auctions are used for perishable commodities such as fish and tobacco. This type of auction is not widely practiced today.

• Sealed first price bid: also known as the blind auction, this is a form of auction where all the bidders instantaneously submit their sealed bids in a way that no participant knows the bid of any other bidder. The highest bidder pays the price they submitted. This form of auction is different from the English auction, in that bidders can only submit one bid each. Moreover, since bidders are not allowed to see the bids of other bidders, they cannot change their own prices as a result. This type of bid has been argued to be tactically comparable to the Dutch form of auction. The sealed first-price type of auction is commonly used for tendering for procurement by companies and organisations, particularly for government contracts in Nigeria today.

WINNERS CURSE.

The winner’s curse is an occurrence that may happen in common value auctions with high asymmetric information. Furthermore, the winner’s curse postulates that in a sealed bid auction, the highest bidder will tend to overpay. The winner may overpay or be “cursed” in one of two ways:

1) The winning bid exceeds the value of the auctioned asset such that the winner is worse off in absolute terms; or

2) The value of the asset is less than the bidder predicted, so the bidder may still have a net gain but will be worse off than expected.

However, an actual overpayment will normally occur only if the winner fails to account for the winner’s curse. The winner of an auction is the bidder who submits the highest bid. Since the auctioned item is worth approximately the same to all buyers, they are distinguished only by their individual assessments of the market value of that particular item. The winner, then, is the bidder making the highest estimate. If we assume that the average bid is accurate, then the highest bidder overvalues the item’s value. Thus, the auction’s winner is likely to pay higher for that item. There is often confusion that winner’s curse applies to the winners of all auctions. However, but when the item is preferred irrespective of its average market value, winner’s curse does not arise. Similarly there may be occasions when the average bid is too low relative to outside market conditions. For example a scenario where a dealer identifying that an item or commodity is highly marketable in another place when the bidders do not have the necessary expertise.

BIDDING STRATEGIES

When bidders do not hedge their value of an item in a competitive auction, they will likely pay too high a price for an item, if they win an auction. The expected loss can be quantified under very general conditions using simulation modelling.

To avoid the winner’s curse, rational bidders are expected to pick a valuation model cautiously and then decide on a suitable price for their final bid. The expected profit, as a function of hedging percentage, has a maximum at the point where the trade-off between risk and reward is best. This optimal hedge can also be found using simulation.

In the usual case where competitor-bidding strategy is unknown, a range of bidding strategies, for both the bidder and the competitor(s), can be simulated and then economic game theory can be used to determine the optimal bidding strategy. While this type of analysis cannot guarantee an outcome or provide assurance that the winner’s curse will be avoided, the resulting bidding strategy can provide the bidding decision-maker with the best opportunity for success.

In this type of auction (one stage sealed bid) where there is high level of asymmetry and uncertainty, the optimal bidding strategy I would go with is the BID SHADING STRATEGY.

BID SHADING

In an auction, bid shading describes the practice of a bidder placing a bid that is below what they believe a good is worth.

Bid shading is used for one of two purposes. In a common value auction with high asymmetric information, bid shading is used to compensate for the winner’s curse. In such auctions, the good is worth the same amount to all bidders, but bidders don’t know the actual value of the commodity therefore they must independently estimate the price. Since all bidders value the good equally, the winner will generally be the bidder whose estimate of the value is largest. But if we assume that the bidders estimate the value accurately, then the highest bidder is most – likely to overestimate the good’s value and might end up paying more than it is worth. In other words, winning the auction carries bad news about a bidder’s value estimate. An understanding bidder will anticipate this, and reduce their bid accordingly.

Bid shading is also used in First-price Auctions, where the winning bidder pays the amount of his bid. If a participant bids an amount equal to their value for the good, they would gain nothing by winning the auction, since they are indifferent between the money and the good. Bidders will optimize their expected value by accepting lower odds of winning in return for a higher payoff if they win.

In a first-price common value auction, a savvy bidder should shade for both of the above purposes.

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