Auction strategies you can learn from different auction formats
Have you tried to buy a house at an auction?
If so, you’d know how nerve-wracking the experience can be.
You’re under time pressure, and you’re trying to do multiple things at once: keep calm, scan the crowd, figure out who the serious bidders are, adjust your strategy to account for how others are bidding, prepare for a dark horse in the crowd who’ll throw a bid at the last minute.
And if you’ve ever made a winning bid, did you end up regretting how much you spent? If you did, you’ve suffered “winner’s curse.”
Auctions are social experiments.
Savvy real estate agents and auctioneers will deliberately choose a specific “design” for their auctions to make you to behave in certain ways without you realising it.
So how do you get a grip on your own behaviour?
Last week, two American economists — Professors Robert Wilson and Paul Milgrom — won the Nobel Memorial Prize in economics for explaining how humans behave in different auction formats.
They’ve spent decades figuring out how different auction formats create different behaviours, and how different auction rules can create wildly different outcomes.
I wrote a small article about it, and some readers wanted to know more about specific auction formats.
So, here’s a list of some of the most famous ones.
Imagine yourself bidding in each format. What strategies would you use to make the winning bid?
This format will be familiar to most Australians.
It’s used to sell everything from houses and land to livestock, antiques, and art.
The auctioneer starts with a low price and a bidder accepts it, then the auctioneer calls out a slightly higher price and a different bidder accepts that.
Then the auctioneer calls out higher and higher prices, with different bidders battling it out, until one bidder is left and no one’s willing to make a higher bid than that price. That’s when the auction ends.
Think about what’s happening in this format.
As a bidder, you’re able to adjust your strategy in real time, as the auction develops, because you can hear other bids.
Do you like hearing other bids?
What if someone comes in with a huge bid? Would it disconcert you?
Would it make you wonder why they’ve made such a large bid? Do they know something about the house you don’t? Would you be less willing to keep bidding?
In this format, economists have found auctioneers can increase their revenue by sharing more information with bidders about the good being auctioned before the bid takes place, so be wary of that outcome.
This works like the English auction, but in reverse.
The auctioneer starts with a high price and drops the price in small increments until someone calls out a bid. Whoever makes the first bid wins.
This type of auction can be over quickly — a sale occurs with a single bid.
What would your strategy be in this format?
As a bidder, you may be tempted to make a higher bid than you would otherwise want to, to ensure you win the item. But then you’d never know how low the price could have fallen before you won it with a potentially lower bid.
Or would you choose to hold out for a bit, to test your luck and hope no one makes a bid before you, so you can get it for a cheaper price? That would be risky.
You’re essentially trying to guess the “willingness-to-pay” of other people in the crowd with little information about what their willingness-to-pay is.
It’s called a Dutch auction because this format has been used in Holland for centuries to sell everything from flowers, to paintings, to estates.
Another name for this format is an “open-outcry descending-price auction”.
In this type of auction, bidders submit their bids in an envelope.
The envelopes are all opened at the same time and the person with the highest bid wins.
What’s your strategy in this format?
Interestingly, it should be exactly the same as your strategy in a Dutch auction.
In both auctions, no one gets to know the bids of anyone else before the winning bid is announced. And the highest bid wins.
Therefore, there’s “strategic equivalence” between a sealed-bid auction and a Dutch auction. That means both formats offer identical strategies to bidders, and the formats produce the same pay-off.
Sealed-bid auction formats are often used by governments to buy the services of an organisation.
Often known as a “tender,” the government awards the job to the organisation that makes the lowest bid (i.e. to the organisation that says they can provide the services the government wants for the least cost).
That’s how government tenders should work in theory, anyway.
This type of auction was first analysed by Nobel laureate William Vickrey in 1961.
It’s a “second-price, sealed-bid auction”.
Bidders submit their bids in a sealed envelope, and the winner is the bidder who submits the highest price. However, the winner doesn’t pay the highest price — they pay the second-highest price.
That’s why it’s called a “second-price” sealed-bid. This type of auction format is the foundation eBay’s auction design.
What would your strategy be in this format?
According to the economics literature, the dominant strategy for a Vickrey auction with a single, indivisible item, is for everyone to bid their true value.
The theory goes: if your willingness-to-pay for an item is $100, you won’t want to pay more than that. It’s in your interests to bid your true value because if you win, by bidding $100, you’ll end up paying slightly less than that, because you’ll have to pay the second-highest bid, which may be $95.
Therefore, it’s a win-win for you: you’ve won the item, and you’ve paid less for it than you were willing to pay.
Is there any way to game this auction format?
Perhaps you’d make an outrageously high bid to ensure you win, believing you’ll be paying a far lower, more rational, second price anyway. But what if that strategy backfired because some other lunatic made an outrageously-high bid too? You would have gamed yourself. It’s not a good strategy.
One problem humans face during auctions is being overwhelmed by emotion, including the competitive rush to win.
So if you familiarise yourself with different auction formats and learn their dominant strategies, you’ll be better prepared to remain calm and rational when bidding.
Good luck. At the end of the day, you don’t want winning to be a curse.