Auction theory is exceptionally relevant today, as it sets the theoretical backbone of auctions with major financial implications like allocation of licenses, or privatization of public sector companies etc. It analyses various auctioning methods on the basis of their efficiency, the revenue they generate and the equilibrium bidding strategies.
This concept note contrasts the two most commonly used auction designs. Before that, it is essential to know what a sealed bid auction is: the bidder’s identity is kept anonymous, and no one knows what others are bidding. This is important in order to prevent gaming.
First Price Sealed bid Auction: The highest bidder takes the underlying asset and pays the price (s)he quoted
Second Price Sealed bid Auction: The highest bidder takes the underlying asset, and pays the price the second highest bidder quoted
The more commonly used auction is the first price sealed bid auction, but it is inefficient as it does not incentivise the bidder to reveal his true value. Let us investigate this highly loaded statement through a game.
Let us assume that a pen is being auctioned. X values the pen at Rs. 100.
Bidder reactions under different auction designs:
First Price Sealed bid Auction:
Thus, one does not bid one’s true valuation in case of first price sealed bid auction. One chooses to shade ones bid (i.e. bid 99 instead of 100).
Second Price Sealed bid auction: Recall that in this case, the highest bidder takes the asset at the second highest price.
As it can be seen from the above example, it is in the interest of a bidder to reveal his true valuation in case of a second price sealed bid auction visa vis a first price sealed bid auction.
On the side: Winners’ Curse
This occurs when the valuation of the underlying asset is very discretionary, as there is heavy asymmetric information (which is usually the case). In such a situation, the winner, who is the highest bidder, always feels that he may have overvalued the asset compared to everyone else.