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Are auctions for ecosystem service provision likely to suffer with repetition?

Andrew Reeson, Tim Capon and Stuart Whitten CSIRO Ecosystem Sciences, Canberra, Australia Abstract Repeated discriminatory price auctions are now routinely used in Australia for the procurement of ecosystem services from landholders. Whilst such auctions have been demonstrated to be highly efficient in a one-shot setting, it is less clear whether this efficiency will be maintained with repetition, particularly as information about previous auction results is disseminated amongst participants. This paper presents the results of laboratory experiments designed to test the performance of repeated discriminatory price procurement auctions (reverse auctions) under three different levels of information (about own and others bids and values) and two levels of competition (with different budgets resulting in different proportions of participants being successful in each auction). In the more competitive auction we found that average offer prices declined with repetition, suggesting participants were learning to be more competitive. Participants with higher environmental values tended to maintain or increase their offer prices with repetition, while those with lower environmental values tended to decrease offer prices over time. Increasing information about others offers led to faster declines in average offer prices. In the less competitive treatment average offer prices did not decline between rounds. Auction efficiency was found to be higher when more information was available to participants, but tended to decline with repetition, particularly in the less competitive setting. However, the auctions still remained relatively efficient. The results suggest that repeated procurement auctions can remain efficient provided competition can be maintained. Information about previous auctions is not sufficient to inhibit competition, and actually leads to increased efficiency as participants learn to be more competitive. We compare the results of these laboratory experiments to experience in a case study region where multiple ecosystem service auctions have been run over the last few years. Again there is no evidence of any decline in the performance of discriminatory price auctions with repetition. Overall these results suggest that repetition per se need not be a problem with auctions for ecosystem services, provided that the auction is competitive. If competition is limited then an auction is unlikely to be the most appropriate mechanism. Keywords: Auctions; payments for ecosystem services; competitive tenders; experimental economics

Introduction Economic theory demonstrates that auctions can efficiently allocate scarce resources among competing bidders. Auctions are being increasingly used for public procurement, including in the procurement of ecosystem services. Many payment for ecosystem service (ES) schemes now use auction-like mechanisms, with landholders submitting bids (technically offers) for funding to provide ES. Examples include the US Conservation Reserve Program (CRP) (Khanna and Ando 2009) and a number of Australian ES incentive programs (Stoneham et al. 2003; Windle et al. 2009; Reeson et al. 2011). In such auctions, bids are typically ranked in terms of cost effectiveness, expressed in the quantity of ES provided per dollar requested; bids are accepted beginning with the most cost effective until the available funds are exhausted, an ES provision target is met or a reserve price is reached. Much auction theory is focussed on uniform (second) price sealed bid auctions, in which all successful bidders receive (or pay) a single price based on the nearest unsuccessful bid. Uniform price auctions have been proven, both theoretically and empirically, as capable of revealing bidders underlying values and efficiently allocating scarce resources. However, ES auctions tend to use the discriminatory price format, in which successful bidders receive the price they requested rather than a single market clearing price. Discriminatory price auctions extract a greater share of the surplus from bidders (who are generally uninformed about the value of the ecosystem services they are providing) to the benefit of the buyer (the public agency, who sets the rules) (Cason et al. 2003; Stoneham et al. 2003). They may also be favoured by policy makers because the metric used to value bids (e.g. a biodiversity benefits index) is often difficult to communicate to participants, so the basis on which the uniform price is calculated would lack transparency. While uniform price auctions are well studied, less is known about the theoretical and empirical properties of discriminatory price auctions. Essentially a discriminatory price auction is analogous to a first-degree price discriminating monopsonist; the total value created should be the same, but the distribution will change (Stoneham et al. 2003). A key difference from the uniform is that in the discriminatory price format, sellers surplus must be included in the offer price, rather than secured against the (uniform) market clearing price. This may enable a buyer (in a procurement auction) to extract more surplus. For a budget constrained public agency, this will enable more conservation to be purchased for the funds available (Cason and Gangadharan 2005); for example, in Australias Bushtender auction 25% less biodiversity would have been purchased had a uniform price mechanism been used, assuming bidding behaviour was unchanged (Stoneham et al. 2003). However, bidders may be expected to adjust their behaviour since bidding ones private value is a not a dominant strategy beyond the uniform second price auction (Dittrich et al. 2012). They will do this by adding a premium to their bid in order to extract surplus for themselves, which will compromise the information revelation quality of the auction (Milgrom 2004). 2

This potential for strategic bidding was demonstrated in an experimental economic study comparing the two auction formats; sellers in the discriminatory price format were found to inflate their bid prices in an attempt to seek a surplus, which meant that low cost providers were often not successful in the auction, reducing the effectiveness of the auction compared to the uniform price format (Connor et al. 2008). In an ES procurement setting, the purchasing agency may still benefit from a discriminatory price auction; the key issue is whether the increased buyers surplus is sufficient to counteract the loss of efficiency resulting from strategic bidding. However, even if a discriminatory price auction succeeds once from a buyers perspective, with repetition it may become less efficient as strategic bidding increases (Latacz-Lohmann and Van der Hamsvoort 1997). There is evidence of this occurring in the CRP, with bidders increasing their price premiums over time as they learned about the reserve price, reducing the cost effectiveness of this multi-billion dollar environmental incentive program (Reichelderfer and Boggess 1988; Shoemaker 1989; Kirwan et al. 2005). Laboratory studies of repeated discriminatory price auctions report similar findings. Cason and Gangadharan (2005) found that prices tended to increase with repetition, though the effect was small and the auction remained highly efficient. In this study participants only knew the outcome of their own bids, which would have limited the opportunity for learning during the experiment. Schilizzi and Latacz-Lohmann (2007) found that a discriminatory price auction became less efficient than a fixed-price incentive after just three repetitions due to bidders increasing their prices in order to seek greater surplus. Again participants knew only their own bids; however, they swapped roles in each round which would have provided increased opportunity to learn about the market. The CRP used a reserve price, and bidders learned to adjust their bids to almost exactly match it (Reichelderfer and Boggess 1988; Shoemaker 1989), which meant the auction effectively breaks down to a fixed-price incentive scheme (LataczLohmann and Van der Hamsvoort 1997). While bidders run the risk of missing out if their bid is too high, they retain the option to bid in future rounds so the costs of missing out are low (Horowitz et al. 2009). Impulse balance theory describes the process by which people learn to adjust their bids with repeated experience in an auction (Ockenfels and Selten 2005); in a procurement auction context participants would be expected to reduce their price next time if they missed an opportunity by bidding too high and increase their price if they could have made more money from a higher price. How much people can apply this depends on how much feedback they get; if they do not know about the prices of successful and unsuccessful offers they do not know by how much they could increase their price (Ockenfels and Selten 2005). If more information is revealed bidders are more likely to experience regret through realising that an alternative bid could have been more profitable, which can motivate them to change their behaviour in future auctions (Neugebauer and Selten 2006; Engelbrecht-Wiggans and Katok 2009). If more information is available, sellers may 3

be able to extract greater surplus (Isaac and Walker 1985). Keeping bids confidential (as is typically the case in sealed bid discriminatory price auctions) would limit the amount of information on which participants can base strategic bidding, compared to an alternative in which all bids are made public. However, in reality it is always difficult to restrict information, so it is likely that bidders in repeated auctions may have at least some information beyond their own direct experience on which to base their bids. One way to avoid the problems caused by learning and strategic bidding could be to incorporate some uncertainty into the auction process, for example in the functional form of the bid metric (Latacz-Lohmann and Van der Hamsvoort 1997). In laboratory experiments when the metric was unknown so bidders were uncertain whether their bid had high or low value to the buyer, bids tended to be based on opportunity costs of land-use change; where values were known bidders tended to raise their prices and extract more of the surplus (Cason et al. 2003). In the CRP landholders with high environmental scores have been shown to bid more strategically (Kriwan et al. 2005; Vukina et al. 2008). However, it may not be feasible, or allowable, to withhold metric information from landholders, and in many cases landholders may be able to estimate their relative environmental values even if metric scores are not provided. Our study applies experimental economics to test the performance of repeated discriminatory price auctions under different levels of information. We examined three different information treatments. In the no information treatment participants only knew the outcome of their own bid; in the limited information treatment they saw the bids of their neighbours, but not the rest; in the full information treatment all bids were public. We found that, contrary to previous studies, bid prices actually declined with repetition of the auction. The rate of decline over the first few repetitions was greater when more information about other bids was available. This reduction in prices meant that the auction proved more efficient in the treatments with more information. To further explore this result we carried out another set of experiments in which the competitive pressure in the auction was reduced by increasing the budget available for ES procurement so that bidders were more likely to be successful. Again, information was associated with lower prices and increased efficiency, though with less competition auction performance was eroded with repetition.

Methods Our experimental scenario consisted of a single unit, discriminatory price auction. Participants were endowed with a piece of land, which they could either keep and earn its production value, or rent out via an auction in each round of the experiment. Participants could offer their land for rent in each round, and were free to determine their price. If they were successful in the auction their land was rented out for that round of the experiment and they earned the price they had requested in the auction. If 4

they were not successful in the auction (or chose not to enter), they earned the production value of their land. This created a scenario analogous to an auction for ecosystem service procurement in which landholders can enter into temporary agreements to conserve their land in return for a payment but at the expense of production. The experiment did not have an explicit ecosystem services context in order to establish a neutral frame for participants. Land was valued in the auction based on its rentability (analogous to environmental value). Bids made by participants in the auction were ranked according to cost effectiveness (rentability/bid price) and were accepted until a fixed budget constraint was reached. For the first set of experiments the budget was $750 per round; in the second set of experiments (the less competitive scenario) the budget was increased to $1,200. Across the nine participants in each auction there were three different production values ($100, $125, $150) and three different rentability values (10, 15, 20); each participant had a unique combination of values. Each auction covered a single round only. Participants were handed a sheet stating the production and rentability values of their land. They entered their price and handed the sheet back to the experimenter. They did not know the total budget available in the auction. In the no information treatment, sheets were returned to participants marked according to whether or not their bid had been successful in the auction. In the partial information treatment participants were also informed of the rentability, price and outcome of the bids of two other players (the same two players in each round). In the full information treatment the rentability, price and outcome of all bids were announced publicly. Private use values were not revealed to other participants in any of the treatments. The auction was repeated ten times, with participants retaining the same value sets each time. Participants were paid in cash at the end of each experiment based on their total earnings over the ten rounds of the experiment, with 100 experimental dollars converting to one Australian dollar (approximately equal to US$1), in addition to a $15 show-up fee. Earnings ranged from $25.00 to $33.70 with an average of $29.30. Participants were students at the University of Sydney.

Results Lower budget (more competitive) treatments Average bid prices differed significantly between the treatments (Figure 1). Average price per round was significantly lower in the full information treatment compared to the partial and no information treatments; the partial and no information treatments were not significantly different from one another (Table 1). 5

Information had a significant impact on the quantity procured in the auction (which provides a measure of auction efficiency from the purchasers perspective). In the full information treatment, significantly more of the environmental good was procured within the budget compared to the partial and no information treatments; the partial and no information treatments did not differ significantly from one another (Figure 1).
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Figure 1: Average (means +/- standard errors) level of profit seeking (bid price - cost, as a percentage of cost) and auction efficiency (quantity purchased as a percentage of the maximum if all bids were at cost) by treatment.

Average bid prices declined significantly over repeated rounds (Table 1); this decline was most marked in over the initial rounds of the experiment and was sharper in the information treatments (Figure 2). Learning was evident as participants whose bids were unsuccessful reduced their prices by an average of $17 in the following round, while those who were successful increased their price by an average of $8. Separating bidders based on their value (low, medium and high value to the buyer) revealed that while bid prices for low and medium value bidders declined significantly through time (p=0.000; p=0.011), prices submitted by high value bidders did not (p=0.313) (Figure 3). Procurement in the auction declined over time, though only slightly (70% to 67%), and this was not significant at the 5% level (p=0.079).

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Figure 2: Average bid price by round and treatment.

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Figure 3: Average bid price by round for participants with high, medium and low rentability values, for all treatments combined.

Table 1: Regression results (with standard errors) from panel data analysis. Procurement Mean bid price Mean bid price efficiency (per person) (per round) 74.54** 38.25** 186.97** Constant (1.98) (10.97) (4.64) -0.55^ -2.62** Round (0.31) (0.63) No information Partial information 1.02 (1.10) 5.14** (0.69) (reference level) -10.86** (4.10) -17.60** (5.05) -

-10.70* (4.96) -19.18** Full information (5.29) 4.70** Rentability (0.44) 0.51** Opportunity cost (0.08) ^ significant at 0.1; * significant at 0.05; ** significant at 0.01

Higher budget (less competitive) treatments Again, average bid prices differed significantly between the information treatments, decreasing with information (Figure 4, Table 2). In the full information treatment procurement efficiency was also significantly higher than in the no information treatment (Figure 4).

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Profit-seeking
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70% 60% 50% 40% 30% 20% 10% 0%

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Figure 4: Average (means +/- standard errors) level of profit seeking (bid price - cost, as a percentage of cost) and auction efficiency (quantity purchased as a percentage of the maximum if all bids were at cost) by in the less competitive auction by information treatment.

In the less competitive auction, average bid prices increased over repeated rounds, though this was not significant at the 5% level (Table 4). Again, the increase was most marked in the initial rounds (Figure 5). Separating bidders based on their value (low, medium and high value to the buyer) revealed that while bid prices for high value bidders increased through time, while remaining roughly constant for low and medium value bidders (Figure 6). Procurement in the auction declined over time, though again this was not significant at the 5% level (Table 2).

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Figure 5: Average bid price by round and treatment in the less competitive auction.

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Figure 6: Average bid price by round for participants with high, medium and low rentability values, for all treatments combined in the less competitive auction. Table 2: Regression results (with standard errors) from panel data analysis for the less competitive auctions. Procurement Mean bid price Mean bid price efficiency (per person) (per round) 74.73** 10.34 204.79** Constant (2.97) (30.47) (16.13) -1.55^ 2.35^ Round (0.19) (1.20) No information Partial information 4.06 (4.59) 10.85** (2.36) (reference level) -18.58 (17.80) -45.95** (12.54) -

-18.06* (8.31) -29.77** Full information (3.74) 8.35** Rentability (1.12) 0.70** Opportunity cost (0.21) ^ significant at 0.1; * significant at 0.05; ** significant at 0.01

Experimental economics discussion In our experimental scenario the discriminatory price auction remained competitive with repetition. Overall auction efficiency did fall, though only slightly (from 70% in the first round to 67% in the tenth round). Average bid prices also declined as 10

participants learned to be more competitive. With more information about other bids in the auction, competition was more apparent, with average bid prices decreasing as the availability of information increased. In the two treatments with some information about other bids, average bid prices fell rapidly over the initial rounds, while in the no information treatment the decline was much slower (Figure 2). In later rounds there was little difference in average bid prices between the treatments, suggesting that information mediated the timing of price adjustments rather than final prices. With repetition, the lower value bidders learned to reduce their prices in an attempt to remain competitive in the auction. Those with higher values did not on average reduce their prices. However, it is likely that the competitive nature of the auction limited their opportunity to seek higher surpluses. In our scenario the presence of lower value bidders competing on price prevented those with higher values from raising their prices substantially. This highlights the importance of keeping lower value bidders engaged in the auction process, as they can maintain the competitive pressure on the higher value bidders even if they are unlikely to have their bids accepted. In the less competitive auction the efficiency of public good provision did decline with repetition as high value bidders learned to extract a greater share of the surplus. However, information about others bids and values was again associated with lower prices and increased efficiency. It is interesting that this effect persists even with much reduced competitive pressure. It is also notable that prices were lower in the full information treatment from the very first round, before any learning could have taken place. One possible explanation is that publicly announcing results increases peoples motivation to win the auction, resulting in more competitive bidding behaviour (see Corrigan et al. 2012). There was no evidence of collusion in these auctions. Experimental studies have found that restricting demand can provide an avenue for bidders to collude (Alsemgeest et al. 1998; Goeree et al. 2006; Burtraw et al. 2009). In our single unit auction this option was not available. Where landholders have flexibility around the quantity of ecosystem services they offer, for example by deciding how many fields to include in their offer, there may be more opportunities for collusion in repeated auctions. Field case study Fourteen separate auctions for ecosystem services provision have been run since 2006 in the Wimmera Catchment in western Victoria, Australia. While these have targeted a variety of services in different parts of the catchment, there are two examples where essentially the same auction has been run four times in particular regions of the catchment, allowing us to look at the performance of repeated auctions in the field. The first example, an auction for the procurement of revegetation (tree planting for salinity mitigation), is detailed in Table 3. There is considerable variation in the cost 11

effectiveness of bids over the four rounds. The price paid per unit of ecosystem service ranged from $52 in round one to $11 in rounds two and three. The price paid per hectare was lowest in round one ($1,137) and highest in round three ($2,062). There is no evidence of any relationship between the cost (as expressed in the bid price) per hectare and the level of ecosystem service provided per hectare, with both measures showing considerable variation. These data show there is somewhat greater variability in the metric scores (ES/ha) than in the costs ($/ha), suggesting that the metric is the single most important component in bid selection. Over rounds one, two and three costs per hectare increased, but ecosystem service provision increased at a greater rate, resulting in improved cost effectiveness of investment.
Table 3: Performance of revegetation auction rounds 1 to 4 All Bids Round 1 2 3 4 $/ha $1,362 $4,905 $2,134 $1,228 ES/ha 20 120 174 50 $/ES $67 $13 $12 $24 $/ha $1,137 $1,343 $2,062 $1,221 Successful Bids ES/ha 22 120 178 53 $/ES $52 $11 $11 $23

The second example covers the provision of habitat protection for biodiversity conservation. These actions show a similar pattern to that seen in the revegetation auctions, with prices per hectare rising through time while costs per unit of ecosystem service tend to be lower in the later rounds than in the initial rounds of the auction (Table 4). Again, metric scores increased much more than costs per hectare as the auction was repeated. The variance in metric scores was also much higher (as a proportion of the mean) than the variance of costs. Again this indicates that the metric is the most important aspect of bid selection.
Table 4: Performance of habitat protection auction rounds 1 to 4

All Bids Round 1 2 3 4 $/ha $1,076 $1,536 $1,807 $4,668* ES/ha 4,796 18,822 16,140 41,142 $/ES $0.22 $0.08 $0.11 $0.11 $/ha $891 $1,028 $1,622 $2,494*

Successful Bids ES/ha 5,202 20,937 17,179 80,420 $/ES $0.17 $0.05 $0.09 $0.03

* Note the majority (82%) of bids in round four were for 10 year contracts; rounds one, two and three offered five year contracts only.

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While not directly comparable to the experimental data, these field data nonetheless provide a further line of evidence to suggest that ES auctions do not necessarily show a decline in performance with repetition. In both examples the costs per unit of ES provision did not increase, and in fact the first round proved the least cost effective. The changes seen over time in these auctions are as likely to be due to changes in participation rates among landholders as learning by individual landholders (though many did submit repeated bids). However, after four repetitions the auctions clearly remain a cost effective tool for a public agency to procure ecosystem services. Overall these results suggest that running repeated discriminatory price auctions for the procurement of ecosystem services need not result in a substantial decline in auction efficiency. Learning cannot overcome competition, so if the initial auction environment is competitive it should remain so. However if values are distributed unevenly so that a small number of bidders can dominate supply, learning may result in increased surplus for those bidders and a decrease in auction efficiency. There is no evidence that information about previous auctions can disrupt performance, provided there is still competition. Auction design should focus on the fundamentals of providing participants with the incentive to accurately reveal their costs of ecosystem service provision, and ensuring that participation is sufficient. Those designing auctions should ensure that transaction costs are minimised to keep lower value bidders participating, which will limit the ability of higher value bidders to succeed with bids far in excess of their costs. References
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