At their simplest, auctions offer a way for sellers and buyers to fairly and dynamically identify a price on which they mutually agree, without the complexity and time consumption of myriad individual negotiations.
But even without active manipulation, auctions can be distorted and made less efficient — producing less money for sellers, or reducing satisfaction for buyers — based on the impact of unintended social and psychological forces.
These distortions generally come about because one or more of the theoretical characteristics of fair and efficient auctions are not met under real-world circumstances. Auction designers face the challenge of creating auctions that are not just resilient to active manipulation, but also resistant to the volatile and discontinuous reality of their buyer and seller landscape.
Risk-averse bidders are strongly motivated to reduce uncertainty, which affects their bidding strategy. This means in first-price sealed-bid and Dutch auctions, risk averse bidders will bid higher than they might otherwise; with only one chance to bid, they tend to overbid out of fear of losing the item.
This is not true of English and Vickrey auctions, however; in English auctions, risk-averse bidders receive constant information about what other bidders are willing to pay and can outbid them in real time, while in Vickrey auctions, risk-averse bidders pay the second price rather than their own bid, which may be from a bidder who isn’t as risk-averse.
In auction formats where bidders can obtain information about other bidders’ valuation of the item being auctioned, that information will shape their own perceived value of the item. One notable outcome of this is the “winner’s curse,” where the results of the auction convey to the winner that everyone else estimated the value of the item to be lower than they did, generating negative feelings on the part of the winner.
The impact of correlated values on an auction is reduced when there’s less information leakage between bidders. First-price sealed bid auctions have the least information leakage (since bidders only learn the winning bid price and in most but not all cases, the identity of the winner). Second-price sealed bid auctions allow bidders to know the price of the second-highest bidder (and winners know that price and their own bid). Open bid auctions allow information to be transmitted among bidders in real time, and result in the greatest degree of correlated values.
In the real world, potential buyers often have different information or priorities. This creates uncertainties that can often distort the outcomes of auctions. One way that auctioneers can reduce asymmetry of information is by providing as much data about the item being auctioned to bidders as possible, both positive and negative. If this data isn’t provided, the winning bidder may offset their maximum bid based on the estimated cost needed to acquire this information, or simply bid less due to uncertainty, leading to reduced revenue for the seller. By reducing discovery costs for all, sellers can boost the size of expected winning bids and encourage people to bid who might otherwise stay on the sidelines.
Additional payment requirements
In some auctions, the total cost of an item isn’t fully baked into the selling price alone — for example, auctions for items that require ongoing royalties or incentive payments, or that require other extraneous costs of production, supply or maintenance for the item that impact its true value. These additional payments end up getting factored into each bidder’s price function, and frequently in uneven fashion. To reduce the impact of this true-cost uncertainty, auctioneers may choose to make available any and all information that they have about projected extraneous costs, as well as to transparently disclose historical bid data — both of which can stimulate more competitive bidding.
All of these factors can be mitigated in different ways by auction design. But designing auctions to be resilient to active bidder collusion can be harder. The challenge, of course, is that auction designs that address buy-side distortions can make those on the sell-side worse.
Want to learn more about mitigating buy-side auction distortion? Read our in-depth article here.