Auction

What Is an Auction?

An auction is a process in which property is sold through bids. Although most people think of the English variation when this term is mentioned, there are other formats with their advantages.

Whether you are attending a high-profile sale with multi-million dollar artworks or an eBay scuffle for a pair of new kicks, the core rules and procedures are likely the same.

In most cases, bidders submit prices at which they are willing to purchase the goods. Interested buyers offer higher and higher prices to win. The property goes to the highest bidder when the bidding concludes.

Auctions have taken place traditionally in person, with an auctioneer calling out bids in real time. While this practice continues today, some online auctioning platforms have adapted the process to incorporate the ease and accessibility of the Internet.

One example is eBay, an online platform where sellers can sell products ranging from crafts to antiques. They start by setting a reserve price, the lowest amount they sell for. The seller is only obligated to part with their product if this price is reached.

In addition, sellers can select a time frame for this process. The product is sold to the highest bidder when the sale concludes. This is a critically different characteristic than the traditional process, which typically concludes when the bids slow down and eventually stop.

Because of this difference, eBay buyers sometimes employ bid sniping, in which someone tries to bid at the end of the timer to avoid competition. Even software can automate this process to maximize someone’s chances of winning.

Purpose of an Auction

The goal is to maximize the benefit of both the seller and the buyer because they are a voluntary exchange. To achieve this goal, let’s examine this problem through the lens of Pareto efficiency and profit maximization.

The former goal refers to the characteristic that the outcome is the best possible result. In other words, you cannot help one person without harming the other. 

This means that the goods should be sold to the person who values them most. If people’s bids reflect anything about their valuation of the products, it shows that the highest bidder should value the good most.

The second goal is easier to explain. The seller seeks to make a profit, so the sale should be designed to ensure the seller gets the most value. 

Auctions are more useful than direct transactions because the increased demand for the product will typically translate into a higher price. Intuitively, more people will value the good highly as more and more people participate.

From a statistical standpoint, this would increase the range of the bids and raise the selling price. Another way sellers ensure that they maximize their profit is by setting a reserve price. This value represents the lowest selling price that the seller would permit.

In many situations, the reserve price is not disclosed to the bidders. If a participant beats the other buyers, they may only purchase the product if the reserve price is met.

This is also a feature in online eBay auctions, where sellers can set a predetermined price that is not visible to the buyers. However, eBay displays a note when the reserve price is met during the bidding process to notify buyers that any further bidding will be binding.

Types of Auctions

Although most function similarly, there are variations between how bids are collected and how the paying amount is determined. It is important to note that the differences affect what situations they work best in.

Bids may occur in person, online, or from a distance, depending on the format. The structure of the bidding can also vary. In some cases, the bidding increases from a low price to a high one. In other situations, the price declines until a bid is offered.

Some formats also promote anonymity by allowing bidding in secret, with each offer only being known to the seller. These variations require further analysis of the game theory behind them because each person’s actions depend on others’ choices.

As we proceed through each bidding format, please note how people are incentivized to portray themselves and their bids. This will affect whether they bid truthfully, which will, in turn, lead to whether the format is Pareto efficient and profit-maximizing.

1. English auction

As the most prominent bidding structure, this style involves incremental bid increases until no further offers are extended. In addition, bids are public as soon as they are received, allowing participants to compete in real time.

In this form of selling, the product is sold to the highest bidder at the price they offer. As a result, this structure is Pareto efficient. However, it is not profit maximizing because the highest bidder would not have to pay their maximum price.

To illustrate this point, consider the following situation involving two bidders. One participant is willing to pay $500 for a second-hand laptop, while the other is only willing to pay $100. 

In this format, the first participant can win by paying the bid increment above $100—for example, $101. However, because the seller misses out on $399 of potential profit, this format is not profit maximizing.

2. Dutch auction

This is an interesting variation that changes the bidding format. Instead of starting at a minimum price and raising it gradually, these start at the top and slowly lower the price until a buyer accepts it.

Compared to their traditional counterparts, these also do not require a human auctioneer. Most of these are conducted using a device that displays the current price as it decreases. 

Because the sale ends as soon as someone accepts the price, this structure expedites the selling process, making it considerably faster than the English bidding structure. 

Now, let’s consider whether it meets our two goals. First, the price a participant would choose to bid depends on their perception of the competitors. If someone misperceives another participant’s willingness to pay, they may end up bidding too late.

As a result, this format is not guaranteed to produce a Pareto-efficient outcome because people often miscalculate, which means the person who values the good the most might not win.

Similarly, because participants’ bids are based on their perceptions of other people’s willingness to pay, the resulting price is also not profit maximizing. Again, let’s evaluate the same example.

Although Participant A is willing to pay $500, if they believe that Participant B is willing to pay $200, they would bid slightly higher than that. Sold at $225, the seller still needs to be satisfied because they could earn $500.

3. Sealed-bid auction

Using sealed bids incorporates anonymity and speed into the process by utilizing one round of bidding through sealed envelopes. The goods or services are then sold to the highest bidder.

This process resembles the Dutch variant in that the offers are also based on assumptions about other people’s bids. To illustrate this, consider the following point: you wouldn’t bid $1,000 for something worth $10 to other people.

Even if you valued it highly, you might only pay $100 to ensure that you will beat any competition. However, because this also relies on perception, it could be more Pareto-efficient and profit-maximizing.

However, a virtue of this format is that it allows the bidding to take place quickly and from afar. This format is typically used to sell work to contractors, who would each bid however much they are willing to accept as payment. 

In this case, the seller sells the job to the contractor willing to accept the lowest amount.

4. Vickrey auction 

Finally, let’s analyze the Vickrey variation, which puts an interesting twist on its sealed-bid relative. While other aspects remain the same, this structure allows the winning bidder to purchase the product at the second-highest bid.

While this may seem like an insignificant detail, it changes incentives entirely. Due to the new characteristic, participants no longer have to guess what others are willing to pay. Instead, it is best to bid however much they value it.

Let’s return to our example. Participant A, who values the laptop at $500, will now bid the entire amount because they are willing to pay any amount less than that. They are focused on winning instead of predicting their opponent’s reservation price.

This subtle change alters the incentives of the sale so that each participant bids their willingness to pay; as a result, this form is both Pareto-efficient and profit-maximizing.

Examples of Auctions

You might find a real-world example taking place in your neighborhood. When property owners fail to make mortgage payments or stay up to date on their property taxes, a type of ad valorem tax, entities can have the power to sell the house in this way.

1. Let’s start by considering the first situation. Mortgages, approved by banks and other lending institutions, are long-term loans for new homeowners purchasing a house. In this case, the house secures the loan. The bank can seize it as collateral if the borrower defaults on loan repayment.

This can happen when someone misses their loan payments several times. The bank seizes the house to prevent loss on its end and can force you out of your home by law.

2. In the second scenario, failure to pay property taxes can also have similar results. Property taxes are taxes that are imposed upon properties, such as a house, that provide funding to various levels of government. They are calculated according to the value of the house.

Depending on which property tax you fail to pay, that level of government can seize the property and sell it. 

These property sales usually occur through this process, allowing prospective homeowners to bid on the property. Compared to the standard process of buying a home, this format typically concludes at a lower price.

However, these homes may need to be in better condition when sold. Furthermore, there is typically no opportunity to inspect the home before purchasing it.

As a result, it is always best to weigh your options and check through the legal contracts of a foreclosed property before deciding to purchase it. If possible, do some research into the property to ensure that the investment is worthwhile.

Different Ways to Bid in Auctions

While you may imagine a room filled with eager buyers yelling out prices, this is only sometimes how they are conducted. In many cases, the buyers are away from the room when they bid. 

In some cases, buyers may bid virtually or by phone, which allows greater flexibility in the buying process. By doing so, buyers can attend auctions even when they cannot be physically present.

1. Telephone bids

In the case of phone bidding, prospective buyers convey bids via telephone to the auction house. Therefore, before the event, these participants need to communicate their interest in bidding this way to receive a call when it takes place.

This format, however, can be risky since phone connections are only sometimes stable. As a result, you should tell the auction house how high you are willing to go for a particular item ahead of time. Doing so allows them to place bids for you if your connection breaks.

Check out this video on the sale of Leonardo Da Vinci’s “Salvator Mundi” in 2017, which largely took place through telephone bids:

2. Proxy bids

Similarly, some bidders prefer to stay anonymous, leading them to hire specialists who bid for them. In the auction house, these proxies allow their clients to participate without drawing attention to themselves. This format is also preferable to people who are unwilling to travel.

3. Online bids

As illustrated by eBay examples, online bidding has grown more popular in recent years. This structure allows buyers to partake in the bidding process in real time by conveying their offers through the website platform. 

However, because access to platforms like eBay relies on the Internet, you need better connections to place your bids at the right time. Similarly, if the platform crashes, you may lose the opportunity to win the item.

4. Pre-auction absentee bids

This type of bidding functions like proxy bids in that prospective buyers set their highest bid ahead of time. The auction house bids for the buyer and exits if the price exceeds the limit. As a result, this allows more flexibility for the buyers.

Researched and authored by Haimeng Yang |  LinkedIn

Reviewed and edited by Naveeth Rishwan

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