It’s important to remember that auctions are just one of an array of different mechanisms for vending and distributing goods. And just as there’s no one-size-fits-all format for all auction applications, auctions aren’t always the best or most appropriate allocation mechanism for all goods and all markets.
For example, there are list-price sales, where transactions are made at fixed, predetermined prices; “first come first serve” distribution, still used today in circumstances like “hypebeast” drops of limited-edition apparel; and lotteries, which are often held when the allocating party is less concerned with who receives the assets than that as many people participate as possible.
While cryptocurrencies and other fungible tokens are likely to use other pricing mechanisms, NFTs and other digital assets, however, have features that render them especially well-suited to auctions. In particular, because NFTs are often idiosyncratic and lack firm pricing precedents, auctions can prove vital to facilitating their price discovery, much like in physical art markets.
The only caveat is that NFT auctions are still subject to irrational price fluctuations caused by the “Keynesian beauty contest.” A beauty contest is an allegory introduced by John Maynard Keynes, in which he imagines a competition where every participant is asked to choose the six most attractive faces from a hundred photographs. Those who submit the most popular faces get a prize. Because of this incentive, participants don’t end up answering based on their personal opinion, but on what they think others believe is the average opinion, or even more complicated attempts to “game” the system.
At the same time, this isn’t an issue with auctions — it’s a fundamental problem for any circumstance where assets are being allocated in the absence of intrinsic values or firm precedents. No other pricing mechanism provides a better solution than auctions.
Perhaps the best-known application of auctions in blockchain is their use in how the Ethereum gas fees are determined. As we’ve noted before, on the Ethereum network, users who need to process transactions submit bids to a first-price auction. The winners pay what they bid and get their transactions confirmed immediately; if not, they pay nothing and have to wait for the next block.
The gas fee auctions balance supply and demand, and guarantee those who value confirmation speed the most get their transactions processed first. While these auctions are efficient in allocation block spaces, they also lead to wild fluctuations in gas fees when the network is under pressure (“congested”), which exacerbates the network’s existing scalability problem and tends to crowd out all but the most lucrative uses of the Ethereum blockchain.
In order to address this problem, the highly anticipated EIP-1559 upgrade proposes a major change to Ethereum’s transaction fee mechanism, which replaces the auction with a varying base fee and a supplementary transaction “tip.” We have yet to find out if this upgrade will achieve what it sets out to do, but one thing is for sure: there is no free lunch in market design. When auctions are not getting the job done, we need to consider alternative market mechanisms, and in the process accept some trade-offs for the prioritized objectives.
Want to learn more about the history and usefulness of auctions? Read our in-depth article here.