How To Design An Auction - Duel Of The Fates

Just in case any of you are going to be holding an auction anytime soon, I thought I'd better do some kick ass auction economics.

Auctions are everywhere. eBay. Sotheby's. Daytime TV (a big shout out to all you arts students). They can raise huge sums of money; the UK Government got a massive £20 billion when it auctioned off mobile phone spectrum rights a few years ago.

As we saw in a previous blog (The £1 Coin Auction – Money For Nothing) auction design can be very important. Today I shall focus on 4 key types. My next blog will look at a genius experiment that used the internet to see which auction design would be the best to use.

I should start by explaining that I'll call the difference between the sum of money someone actually pays for the auction prize and their valuation of the prize a ‘surplus’. For example, if I pay £10 for GuruHogg t-shirt (no doubt coming soon to an internet near you) but am willing to pay up to £25 for it, then I have earned a surplus of £15. (We assume no-one is willing to pay over their valuation).

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English Auction

This will be very familiar to you, it’s the most common type of auction; used in antique and art auctions worldwide. The bidding starts low and people make higher bids if they wish. The winner is the last surviving bidder. They win the prize and pay the winning bid. 

People will be prepared to bid anything up to their valuation; however, the highest bid will just be marginally more than the runner up’s highest bid. 

Dutch Auction

This is another real-time auction. However, in a Dutch auction the starting price is set really high. It is then lowered incrementally until someone bids. Thus the first bidder wins the prize and pays their entry price.

In this type of auction there is an incentive to wait until the price has been lowered below your valuation, in order to earn a surplus.

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First Price Sealed Bid Auction

This is not real-time. All bidders each submit one bid (which is hidden from other bidders) within a set time frame. The highest bidder wins the prize and pays their bid.

There is an incentive to bid slightly less than your valuation to earn a surplus.

Second Price Sealed Bid Auction

This is another sealed bid auction. All bidders each submit one bid (which is hidden from other bidders) within a set time frame. The highest bidder wins the prize but only pays the runner up’s bid.

Thus there is an incentive to bid your highest valuation (to try and win the prize) in the knowledge that you can still earn a surplus (because you'll pay the runner up’s bid).

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Economists say that the English and Second Price Sealed Bid Auctions are 'strategically equivalent' because people follow the same strategy (because there is an incentive to pay, or be prepared to pay, one’s valuation of the prize). Likewise, the Dutch and First price Auctions are strategically equivalent (because in both there is an incentive to bid less than one’s valuation).

However, in theory economists reckon that all 4 auctions should yield the same sum of money to the seller. The key words here are in theory.

Next time: which auction would actually earn you more money??

Recommended listening:

Duel Of The Fates by John Williams