We usually don’t spend a lot of time thinking about how the prices we pay for many goods or services are determined. But prices can be set in a number of ways. In housing markets, for example, where there’s significant bargaining over prices and other terms of sale, prices are determined in a back-and-forth negotiation between the seller and potential buyers.
Bargaining and posted prices are types of price discovery mechanisms: they’re methods by which sellers determine for how much and under what terms to sell a good or service. Like bargaining and posted prices, auctions offer another method of price discovery.
In housing markets, for example, where there’s significant bargaining over prices and other terms of sale, prices are determined in a back-and-forth negotiation between the seller and potential buyers.
Bargaining and posted prices are types of price discovery mechanisms: they’re methods by which sellers determine for how much and under what terms to sell a good or service. Like bargaining and posted prices, auctions offer another method of price discovery.
An elegant result covered in every textbook about auction theory called the revenue equivalence theorem (RET) provides a reassuring starting point to consider when designing auctions. The revenue equivalence theorem states that under a specific set of economic conditions, the revenue an auctioneer can expect to earn and the profit any bidder can expect to make will be the same for a broad class of auctions.
Under the private value model, a bidder’s value is idiosyncratic and would be unaffected by learning any other bidder’s information. For example, when bidding for things that are meant for consumption, like apparel or technological devices, people focus primarily on how much utility they personally might expect to derive from an item.
In contrast, in the common value model, everyone has the same valuation for an item, but different private information about what the value actually is. In this case, a bidder would change her estimate of the value if she learns what the other bidders are willing to pay. A classic example would be auctions for oil drilling rights. Bidders are concerned about the amount of reserve under an oil field. They each collect private information about the reserve by prospecting and assaying the field, and guard the information closely to protect their informational advantage.
Different auction designs can yield different outcomes. Their effectiveness in price discovery is in part shaped by their impact on buyers’ bidding strategies.
Truthful bidding, where bidders submit bids equal to their actual valuation, is a desirable way to achieve an equilibrium in bidding strategies — that is, a situation where each bidder would not do better in the auction by changing their bid.
However, in many other auction settings, in equilibrium, bidders would want to bid less than their own valuation (shading). Outside of the safe space of the RET, shading can be accompanied by a problematic phenomenon called the winner’s curse. Specifically, if different bidders have different information about the same common value, then the person who overestimates it the most will become the winner. The winner gets stuck paying more than the actual worth of the item. Bidders wary of the winner’s curse will shade their bids even more, which in turn reduces the expected revenue of the auction.
Want a more detailed look at solutions for bidding and price discovery? Read our in-depth article here.
