Classification of Auctions

The economic classification of auctions involves two considerations: first, what is the nature of the good that is being auctioned, and second, what are the rules of bidding? With respect to the nature of the good, economists distinguish between private-value auctions and common-value auctions.

In a private-value auction, each participant has a potentially different value for the good in question. A particular piece of art may be worth $500 to one collector, $200 to another, and $50 to yet another, depending on their taste. In a common-value auction, the good in question is worth essentially the same amount to every bidder, although the bidders may have different estimates of that common value. The auction for off-shore drilling rights described above had this characteristic: a given tract either had a certain amount of oil or not. Different oil companies may have had different estimates about how much oil was there, based on the outcomes of their geological surveys, but the oil had the same market value regardless of who won the auction.

We will spend most of the time in this chapter discussing private-value auctions, since they are the most familiar case. At the end of the chapter, we will describe some of the features of common-value auctions.

Bidding Rules

The most prevalent form of bidding structure for an auction is the English auction. The auctioneer starts with a reserve price, which is the lowest price at which the seller of the good will part with it.1 Bidders successively offer higher prices; generally each bid must exceed the previous bid by some minimal bid increment. When no participant is willing to increase the bid further, the item is awarded to the highest bidder.

Another form of auction is known as a Dutch auction, due to its use in the Netherlands for selling cheese and fresh flowers. In this case the auctioneer starts with a high price and gradually lowers it by steps until someone is willing to buy the item. In practice, the "auctioneer" is often a mechanical device like a dial with a pointer which rotates to lower and

1 See the footnote about "reservation price" in Chapter 6.

lower values as the auction progresses. Dutch auctions can proceed very rapidly, which is one of their chief virtues.

Yet a third form of auctions is a sealed-bid auction. In this type of auction, each bidder writes down a bid on a slip of paper and seals it in an envelope. The envelopes are collected and opened, and the good is awarded to the person with the highest bid who then pays the auctioneer the amount that he or she bid. If there is a reserve price, and all bids are lower than the reserve price, then no one may receive the item.

Sealed-bid auctions are commonly used for construction work. The person who wants the construction work done requests bids from several contractors with the understanding that the job will be awarded to the contractor with the lowest bid.

Finally, we consider a variant on the sealed bid-auction that is known as the philatelist auction or Vickrey auction. The first name is due to the fact that this auction form was originally used by stamp collectors; the second name is in honor of William Vickrey, who received the 1996 Nobel prize for his pioneering work in analyzing auctions. The Vickrey auction is like the sealed-bid auction, with one critical difference: the good is awarded to the highest bidder, but at the second-highest price. In other words, the person who bids the most gets the good, but he or she only has to pay the bid made by the second-highest bidder. Though at first this sounds like a rather strange auction form, we will see below that it has some very nice properties.

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