Auction theory is a branch of applied economics that deals with how bidders act in auctions and researches how the features of auctions incentivise predictable outcomes. Auction theory is a tool used to inform the design of real-world auctions. Sellers use auction theory to raise higher revenues while allowing buyers to procure at a lower cost. The confluence of the price between the buyer and seller is an economic equilibrium. Auction theorists design rules for auctions to address issues that can lead to market failure. The design of these rulesets encourages optimal bidding strategies in a variety of informational settings. [1] The 2020 Nobel Prize for Economics was awarded to Paul R. Milgrom and Robert B. Wilson "for improvements to auction theory and inventions of new auction formats." [2]
Auctions facilitate transactions by enforcing a specific set of rules regarding the resource allocations of a group of bidders. Theorists consider auctions to be economic games that have two aspects: format and information. [3] The format defines the rules for the announcement of prices, the placement of bids, the updating of prices, when the auction closes, and the way a winner is picked. [4] The way auctions differ with respect to information regards the asymmetries of information that exist between bidders. [5] In most auctions, bidders have some private information that they choose to withhold from their competitors. For example, bidders usually know their personal valuation of the item, which is unknown to the other bidders and the seller; however, the behaviour of bidders can influence valuations by other bidders.
A purportedly historical event related to auctions is a custom in Babylonia, namely when men make an offers to women in order to marry them. [6] The more familiar the auction system is, the more situations where auctions are conducted. There are auctions for various things, such as livestock, rare and unusual items, and financial assets.
Non-cooperative games have a long history, beginning with Cournot's duopoly model. A 1994 Nobel Laureate for Economic Sciences, John Nash, [7] proved a general-existence theorem for non-cooperative games, which moves beyond simple zero-sum games. This theory was generalized by Vickrey (1961) to deal with the unobservable value of each buyer. By the early 1970s, auction theorists had begun defining equilibrium bidding conditions for single-object auctions under most realistic auction formats and information settings. [8] Recent developments in auction theory consider how multiple-object auctions can be performed efficiently.
There are traditionally four types of auctions that are used for the sale of a single item:
Most auction theory revolves around these four "basic" auction types. However, other types have also received some academic study (see Auction § Types). Developments in the world and in technology have also influenced the current auction system. With the existence of the internet, online auctions have become an option.
There are six basic activities that complement the auction-based trading process: [15]
The auction envelope theorem defines certain probabilities expected to arise in an auction. [16]
The benchmark model for auctions, as defined by McAfee and McMillan (1987), is as follows:
In an auction a buyer bidding wins if the opposing bidders make lower bids.
The mapping from valuations to bids is strictly increasing; the high-valuation bidder therefore wins.
In statistics the probability of having the "first" valuation is written as:
With independent valuations and N other bidders
A buyer's payoff is
Let be the bid that maximizes the buyer's payoff.
Therefore
The equilibrium payoff is therefore
Necessary condition for the maximum:
when
The final step is to take the total derivative of the equilibrium payoff
The second term is zero. Therefore
Then
Example uniform distribution with two buyers. For the uniform distribution the probability if having a higher value that one other buyer is .
Then
The equilibrium payoff is therefore .
The win probability is .
Then
.
Rearranging this expression,
With three buyers, , then
With buyers
Lebrun (1996) [17] provides a general proof that there are no asymmetric equilibriums.
The revelation principle is a simple but powerful insight.
In 1979 Riley & Samuelson (1981) proved a general revenue equivalence theorem that applies to all buyers and hence to the seller. Their primary interest was finding out which auction rule would be better for the buyers. For example, there might be a rule that all buyers pay a nonrefundable bid (such auctions are conducted on-line). The equivalence theorem shows that any allocation mechanism or auction that satisfies the four main assumptions of the benchmark model will lead to the same expected revenue for the seller. (Buyer i with value v has the same "payoff" or "buyer surplus" across all auctions.) [18]
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The first model for a broad class of models was Milgrom and Weber's (1983) paper on auctions with affiliated valuations.
In a recent working paper on general asymmetric auctions, Riley (2022) characterized equilibrium bids for all valuation distributions. Each buyer's valuation can be positively or negatively correlated.
The revelation principle as applied to auctions is that the marginal buyer payoff or "buyer surplus" is P(v), the probability of being the winner.
In every participant-efficient auction, the probability of winning is 1 for a high-valuation buyer. The marginal payoff to a buyer is therefore the same in every such auction. The payoff must therefore be the same as well.
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Quite independently and soon after, Myerson (1981) used the revelation principle to characterize revenue-maximizing sealed high-bid auctions. In the "regular" case this is a participation-efficient auction. Setting a reserve price is therefore optimal for the seller. In the "irregular" case it has since been shown that the outcome can be implemented by prohibiting bids in certain sub-intervals.
Relaxing each of the four main assumptions of the benchmark model yields auction formats with unique characteristics. [18]
The theory of efficient trading processes developed in a static framework relies heavily on the premise of non-repetition. For example, an auction-seller-optimal design (as derived in Myerson) involves the best lowest price that exceeds both the seller's valuation and the lowest possible buyer's valuation.
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A game-theoretic auction model is a mathematical game represented by a set of players, a set of actions (strategies) available to each player, and a payoff vector corresponding to each combination of strategies. Generally, the players are the buyer(s) and the seller(s). The action set of each player is a set of bid functions or reservation prices (reserves). Each bid function maps the player's value (in the case of a buyer) or cost (in the case of a seller) to a bid price. The payoff of each player under a combination of strategies is the expected utility (or expected profit) of that player under that combination of strategies.
Game-theoretic models of auctions and strategic bidding generally fall into either of the following two categories. In a private values model, each participant (bidder) assumes that each of the competing bidders obtains a random private value from a probability distribution. In a common value model, the participants have equal valuations of the item, but they do not have perfectly accurate information to arrive at this valuation. In lieu of knowing the exact value of the item, each participant can assume that any other participant obtains a random signal, which can be used to estimate the true value, from a probability distribution common to all bidders. [19] Usually, but not always, the private-values model assumes that the valuations are independent across bidders, whereas a common-value model usually assumes that the valueations are independent up to the common parameters of the probability distribution.
A more general category for strategic bidding is the affiliated values model, in which the bidder's total utility depends on both their individual private signal and some unknown common value. Both the private value and common value models can be perceived as extensions of the general affiliated values model. [20]
When it is necessary to make explicit assumptions about bidders' value distributions, most of the published research assumes symmetric bidders. This means that the probability distribution from which the bidders obtain their values (or signals) is identical across bidders. In a private values model which assumes independence, symmetry implies that the bidders' values are "i.i.d." – independently and identically distributed.
An important example (which does not assume independence) is Milgrom and Weber's general symmetric model (1982). [21] [22]
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The earliest paper on asymmetric value distributions is by Vickrey (1961). One buyer's valuation is uniformly distributed over the closed interval [0,1]. The other buyer has a known value of 1/2. Both the equilibrium and uniform bid distributions will support [0,1/2].
Jump-bidding;
Suppose that the buyers' valuations are uniformly distributed on [0,1] and [0,2] and buyer 1 has the wider support. Then both continue to bid half their valuations except at v=1.
The jump bid: buyer 2 jumps from bidding 1/2 to bidding 3/4. If buyer 1 follows suit she halves her profit margin and less than doubles her win probability (because of the tie breaking rule, a coin toss).
So buyer 2 does not jump. This makes buyer 1 much better off. He wins for use if his valuation is above 1/2.
The next paper, by Maskin and Riley (2000), provides a qualitative characterization of equilibrium bids when the "strong buyer" S has a value distribution that dominates that of the "weak buyer" under the assumption of conditional stochastic dominance (first-order stochastic dominance for every right-truncated value distribution). Another early contribution is Keith Waehrer's 1999 article. [23] Later published research includes Susan Athey's 2001 Econometrica article, [24] as well as that by Reny and Zamir (2004). [25]
One of the major findings of auction theory is the revenue equivalence theorem. Early equivalence results focused on a comparison of revenues in the most common auctions. The first such proof, for the case of two buyers and uniformly distributed values, was by Vickrey (1961). In 1979 Riley & Samuelson (1981) proved a much more general result. (Quite independently and soon after, this was also derived by Myerson (1981)).The revenue equivalence theorem states that any allocation mechanism, or auction that satisfies the four main assumptions of the benchmark model, will lead to the same expected revenue for the seller (and player i of type v can expect the same surplus across auction types). [18] The basic version of the theorem asserts that, as long as the Symmetric Independent Private Value (SIPV) environment assumption holds, all standard auctions give the same expected profit to the auctioneer and the same expected surplus to the bidder. [26]
The winner's curse is a phenomenon which can occur in common value settings—when the actual values to the different bidders are unknown but correlated, and the bidders make bidding decisions based on estimated values. In such cases, the winner will tend to be the bidder with the highest estimate, but the results of the auction will show that the remaining bidders' estimates of the item's value are less than that of the winner, giving the winner the impression that they "bid too much". [18]
In an equilibrium of such a game, the winner's curse does not occur because the bidders account for the bias in their bidding strategies. Behaviorally and empirically, however, winner's curse is a common phenomenon, described in detail by Richard Thaler.
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With identically and independently distributed private valuations, Riley and Samuelson (1981) [27] showed that in any auction or auction-like action (such as the "War of Attrition") the allocation is "participant efficient", i.e. the item is allocated to the buyer submitting the highest bid, with a probability of 1. They then showed that allocation equivalence implied payoff equivalence for all reserve prices. They then showed that discriminating against low-value buyers by setting a minimum, or reserve, price would increase expected revenue. Along with Myerson, they showed that the most profitable reserve price is independent of the number of bidders. The reserve price only comes into play if there is a single bid. Thus it is equivalent to ask what reserve price would maximize the revenue from a single buyer. If values are uniformly distributed over the interval [0, 100], then the probability p(r) that this buyer's value is less than r is p(r) = (100-r)/100. Therefore the expected revenue is
p(r)*r = (100 - r)*r/100 =(r-50)*(r-50) + 25
Thus, the expected revenue-maximizing reserve price is 50. [28] Also examined is the question of whether it might ever be more profitable to design a mechanism that awards the item to a bidder other than one with the highest value. Surprisingly, this is the case. As Maskin and Riley then showed, this is equivalent to excluding bids over certain intervals above the optimal reserve price.
Bulow and Klemperer (1996) have shown that an auction with n bidders and an optimally chosen reserve price generates a smaller profit for the seller than a standard auction with n+1 bidders and no reserve price. [29]
In the Journal of Economic Literature Classification System, game theory is classified as C7, under Mathematical and Quantitative Methods, and auctions are classified as D44, under Microeconomics. [30]
Scholars of managerial economics have noted some applications of auction theory in business strategy. Namely, auction theory can be applied to preemption games and attrition games. [31]
Preemption games are games where entrepreneurs preempt other firms by entering a market with new technology before it's ready for commercial deployment. The value generated from waiting for the technology to become commercially viable also increases the risk that a competitor will enter the market preemptively. Preemptive games can be modeled as a first-priced sealed auction. Both companies would prefer to enter the market when the technology is ready for commercial deployment; this can be considered the valuation by both companies. However, one firm might hold information stating that technology is viable earlier than the other firm believes. The company with better information would then "bid" to enter the market earlier, even as the risk of failure is higher.
Games of attrition are games of preempting other firms to leave the market. This often occurs in the airline industry as these markets are considered highly contestable. [32] As a new airline enters the market, they will decrease prices to gain market share. This forces established airlines to also decrease prices to avoid losing market share. This creates an auction game. Usually, market entrants will use a strategy of attempting to bankrupt established firms. Thus, the auction is measured in how much each firm is willing to lose as they stay in the game of attrition. The firm that lasts the longest in the game wins the market share. This strategy has been used more recently by entertainment streaming services such as Netflix, Hulu, Disney+, and HBO Max which are all loss-making firms attempting to gain market share by bidding to expand entertainment content. [33]
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Two Stanford University professors, Paul Milgrom and Robert Wilson, won the 2020 Nobel Prize in Economics for advancing auction theory by inventing several new auction formats, including the simultaneous multiple-round auction (SMRA), which combines the benefit of both the English (open-outcry), and sealed-bid, auctions. SMRAs are deemed to solve a problem facing the Federal Communications Commission (FCC). If the FCC were to sell all of its telecommunication frequency slots by using a traditional auction method, it would eventually either give away licenses for free or end up with a telecom monopoly in the United States. [34]
The process of simultaneous multiple-round auctions is that there are three- to four-round auctions. Every bidder seals their bid, and the auctioneer announces the highest bid to all bidders at the end of each round. All the bidders can adjust and change their auction price and strategy after they listen to the highest bid in a particular round. The auction will continue until the highest bid of the current round is lower than the previous round's highest bid.
SMRA's first distinguishing feature is that the auction is taking place simultaneously for different items; therefore, it seriously increases the cost for speculators. For the same reason, sealed bidding can ensure that all bidding reflects the bidder’s valuation of the product. The second difference is that the bidding takes place in numerous rounds and the highest price of bidding is announced each round, allowing bidders to learn more about their competitors' preferences and information and to adjust their strategy accordingly, thus decreasing the effect of asymmetric information inside the auction. In addition, multiple-round bidding can maintain the bidder's activity in the auction. It has substantially increased the information the bidder has about the highest bid, because at the end of every round, the host will announce the highest bid after the bidding. [35]
A Vickrey auction or sealed-bid second-price auction (SBSPA) is a type of sealed-bid auction. Bidders submit written bids without knowing the bid of the other people in the auction. The highest bidder wins but the price paid is the second-highest bid. This type of auction is strategically similar to an English auction and gives bidders an incentive to bid their true value. The auction was first described academically by Columbia University professor William Vickrey in 1961 though it had been used by stamp collectors since 1893. In 1797 Johann Wolfgang von Goethe sold a manuscript using a sealed-bid, second-price auction.
An English auction is an open-outcry ascending dynamic auction. It proceeds as follows.
In common valueauctions the value of the item for sale is identical amongst bidders, but bidders have different information about the item's value. This stands in contrast to a private value auction where each bidder's private valuation of the item is different and independent of peers' valuations.
A Japanese auction is a dynamic auction format. It proceeds in the following way.
In game theory, the war of attrition is a dynamic timing game in which players choose a time to stop, and fundamentally trade off the strategic gains from outlasting other players and the real costs expended with the passage of time. Its precise opposite is the pre-emption game, in which players elect a time to stop, and fundamentally trade off the strategic costs from outlasting other players and the real gains occasioned by the passage of time. The model was originally formulated by John Maynard Smith; a mixed evolutionarily stable strategy (ESS) was determined by Bishop & Cannings. An example is a second price all-pay auction, in which the prize goes to the player with the highest bid and each player pays the loser's low bid.
A double auction is a process of buying and selling goods with multiple sellers and multiple buyers. Potential buyers submit their bids and potential sellers submit their ask prices to the market institution, and then the market institution chooses some price p that clears the market: all the sellers who asked less than p sell and all buyers who bid more than p buy at this price p. Buyers and sellers that bid or ask for exactly p are also included. A common example of a double auction is stock exchange.
The revelation principle is a fundamental result in mechanism design, social choice theory, and game theory which shows it is always possible to design a strategy-resistant implementation of a social decision-making mechanism. It can be seen as a kind of mirror image to Gibbard's theorem. The revelation principle says that if a social choice function can be implemented with some non-honest mechanism—one where players have an incentive to lie—the same function can be implemented by an incentive-compatible (honesty-promoting) mechanism with the same equilibrium outcome (payoffs).
A first-price sealed-bid auction (FPSBA) is a common type of auction. It is also known as blind auction. In this type of auction, all bidders simultaneously submit sealed bids so that no bidder knows the bid of any other participant. The highest bidder pays the price that was submitted.
In economics and game theory, an all-pay auction is an auction in which every bidder must pay regardless of whether they win the prize, which is awarded to the highest bidder as in a conventional auction. As shown by Riley and Samuelson (1981), equilibrium bidding in an all pay auction with private information is revenue equivalent to bidding in a sealed high bid or open ascending price auction.
Revenue equivalence is a concept in auction theory that states that given certain conditions, any mechanism that results in the same outcomes also has the same expected revenue.
A Vickrey–Clarke–Groves (VCG) auction is a type of sealed-bid auction of multiple items. Bidders submit bids that report their valuations for the items, without knowing the bids of the other bidders. The auction system assigns the items in a socially optimal manner: it charges each individual the harm they cause to other bidders. It gives bidders an incentive to bid their true valuations, by ensuring that the optimal strategy for each bidder is to bid their true valuations of the items; it can be undermined by bidder collusion and in particular in some circumstances by a single bidder making multiple bids under different names. It is a generalization of a Vickrey auction for multiple items.
Market design is an interdisciplinary engineering-driven approach to economics and a practical methodology for creation of markets of certain properties, which is partially based on mechanism design. In market design, the focus is on the rules of exchange-- meaning who gets allocated what and by what procedure. Market design is concerned with the workings of particular markets in order to fix them when they are broken or to build markets when they are missing. Market design principles have been implemented in auction theory and matching theory.
The generalized second-price auction (GSP) is a non-truthful auction mechanism for multiple items. Each bidder places a bid. The highest bidder gets the first slot, the second-highest, the second slot and so on, but the highest bidder pays the price bid by the second-highest bidder, the second-highest pays the price bid by the third-highest, and so on. First conceived as a natural extension of the Vickrey auction, it conserves some of the desirable properties of the Vickrey auction. It is used mainly in the context of keyword auctions, where sponsored search slots are sold on an auction basis. The first analyses of GSP are in the economics literature by Edelman, Ostrovsky, and Schwarz and by Varian. It is used by Google's AdWords technology and Facebook.
A Bayesian-optimal mechanism (BOM) is a mechanism in which the designer does not know the valuations of the agents for whom the mechanism is designed, but the designer knows that they are random variables and knows the probability distribution of these variables.
A Prior-independent mechanism (PIM) is a mechanism in which the designer knows that the agents' valuations are drawn from some probability distribution, but does not know the distribution.
Bayesian-optimal pricing is a kind of algorithmic pricing in which a seller determines the sell-prices based on probabilistic assumptions on the valuations of the buyers. It is a simple kind of a Bayesian-optimal mechanism, in which the price is determined in advance without collecting actual buyers' bids.
A sequential auction is an auction in which several items are sold, one after the other, to the same group of potential buyers. In a sequential first-price auction (SAFP), each individual item is sold using a first price auction, while in a sequential second-price auction (SASP), each individual item is sold using a second price auction.
In auction theory, jump bidding is the practice of increasing the current price in an English auction, substantially more than the minimal allowed amount.
The Price of Anarchy (PoA) is a concept in game theory and mechanism design that measures how the social welfare of a system degrades due to selfish behavior of its agents. It has been studied extensively in various contexts, particularly in auctions.
Regularity, sometimes called Myerson's regularity, is a property of probability distributions used in auction theory and revenue management. Examples of distributions that satisfy this condition include Gaussian, uniform, and exponential; some power law distributions also satisfy regularity. Distributions that satisfy the regularity condition are often referred to as "regular distributions".