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AUCTION DESIGN

Auction Environment
1. There is a single seller of a single object.
2. There are n potential risk-neutral buyers, called bidders.
3. ] , [ v v v
L i
= i
th
bidders valuation of the object.

i
v s are realizations of independent and identically distributed random variables.
4. ) (
i
v F , the cumulative distribution function of
i
v , is strictly increasing and differentiable.

Class of Auctions Under Consideration
1. The potential buyers can submit any bid above a specified reserve price.
2. The bidder that makes the highest bid receives the object.
3. All bidders are treated identically.
4. All bidders adopt a common equilibrium bidding strategy, ) ( b , so that ) (
i i
v b b = , where
) (
i
v b > 0.

Examples of Auctions in this Class
First-Price Auction = an auction in which the winning bidder pays his bid.
Second-Price Auction = an auction in which the winning bidder pays the second-highest bid.

Determining Bidder 1s Equilibrium Expected Payment
1
v = bidder 1s true valuation.
1
v = bidder 1s reported valuation [ bid = ) (
1
v b ].

We need to ensure that bidder 1 will adopt the ) (
i
v b strategy, given that all others have adopted
the strategy.

) (
1 1 1
v v = bidder 1s expected profit from reporting
1
v (i.e., bidding ) (
1
v b ) when all other
bidders are reporting their
i
v s truthfully (i.e., bidding ) (
i
v b ).

) ( )] ( [ ) (
1 1
1
1 1 1 1
v P v v F v v
n
=

, (1)
where } { ) ) ( , , ) ( , ) ( ( ) (
2 1 1 1 n v
v b v b v b p E v P

= . (2)

i v
E

denotes expectations regarding all valuations other than those of bidder i .
) ( p is the payment made by bidder 1 when he bids ) (
1
v b and when
n
v v , ,
2
are the realized
valuations of bidders n , , 2 , when these bidders all use the ) (
i
v b strategy.


2

To ensure ) (
i
v b is an equilibrium bidding strategy, we must have:
0

) (
1 1
1
1 1 1
=
=


v v
v
v v
. (3)

Equations (1) and (3) require:

{ } ) ( ] ) ( [
1
1
1
1
v P
v v
v F
dv
d
v
n
=
=

for all v v
1
, (4)

where v is the minimum valuation for which it is profitable to participate in the auction.

v is defined by:
) ( )] ( [ ) (
1
v P v F v v v
n
=

= 0 . (5)

Equation (4) implies:
) (
1
v P =

+
1
) ( ) (
v
v
dv v P v P = dv v F
dv
d
v v P
v
v
n


+
1
1
)] ( [ ) ( (6)

= dv v F v F v v P
v
v
n
v
v
n


+
1
1
1 1
)] ( [ )] ( [ ) (

= dv v F v F v v F v v P
v
v
n n n


+
1
1 1
1 1
1
)] ( [ )] ( [ )] ( [ ) ( . (7)

Equations (5) and (7) imply:
dv v F v F v v P
v
v
n n


=
1
1 1
1 1 1
)] ( [ )] ( [ ) ( . (8)

Equation (8) identifies the equilibrium expected payment by a bidder with valuation
1
v (and bid
) (
1
v b ).

Given this expression for the bidders equilibrium expected payment, we can calculate the
equilibrium bidding strategy, once the details of the auction are specified.


3

EXAMPLE: HIGH BID AUCTION (FIRST-PRICE AUCTION)

If a bidder wins the auction by announcing the highest bid, he pays that bid. Therefore, the
expected payment by a bidder who bids ) (v b is the product of this bid and the probability of
winning the auction with this bid. The probability of winning is the probability that all other
bidders have valuations lower than v . Consequently:
) ( )] ( [ ) (
1
v b v F v P
n
= . (9)
Equation (9) can be rewritten as:
) (
)] ( [
1
) (
1
v P
v F
v b
n
= .

Substituting for ) (v P from (8) provides:
) (v b = } { dx x F v F v
v F
v
v
n n
n


1 1
1
)] ( [ )] ( [
)] ( [
1
. (10)

Consequently:
) (v b =
1
1
)] ( [
)] ( [

n
v
v
n
v F
dx x F
v . (11)

Observation 1. v v b < ) ( for all ] , [ v v v .

Observation 2. 0 ) ( > v b for all ] , [ v v v .

Proof: From equation (11):

) (v b =
) 1 ( 2
1 2 1 1
)] ( [
) ( ) ( )] ( [ ] 1 [ )] ( [ )] ( [
1

n
v
v
n n n n
v F
dx x F v f v F n v F v F


=
) 1 ( 2
1 2
2 2
2 2
)] ( [
) ( ) ( )] ( [ ] 1 [
)] ( [
)] ( [
1

+
n
v
v
n n
n
n
v F
dx x F v f v F n
v F
v F


) 1 ( 2
1 2
)] ( [
) ( ) ( )] ( [ ] 1 [

=
n
v
v
n n
v F
dx x F v f v F n
> 0 . (12)

4
EXAMPLE


v is distributed uniformly on [0,1], and 0 = = v v
L
.


In this case, v v F = ) ( . Consequently,


n
v
n
v
n
v
n
v x dx x dx x F
n n
1 1
0
0
1
0
1
)] ( [ = = =


.
(13)

Equation (13) implies:
n
v
v
v
v F
dx x F
n
n
n
n
v
n
= =

1
1
1
0
1
] ) ( [
)] ( [
. (14)


Therefore, from equation (11):
v
n
n
n
v
v v b
(


= =
1
) ( . (15)

Note: { } 0
1
) 1 (
1 1
2 2
> = =
)
`


n
n n
n n
n
dn
d
.



Implication: For the uniform distribution, the magnitude of bid shading declines as the number
of bidders increases.


Note: When 2 = n , v v b
2
1
) ( = . As n , v v b ) ( .


5
SECOND PRICE (VICKREY) AUCTION
1. All bidders announce their bids simultaneously.
2. The bidder who submits the highest bid wins the object, and pays the second-highest bid.

Proposition: Truthful revelation of ones valuation (i.e., v v b = ) ( ) is a dominant strategy for
each bidder under the second-price auction.

Outline of Proof.
1. Consider the optimal strategy of bidder 1 (with valuation =
1
v ) when the other bids are
n
b b b < < <
3 2
.
2. Case 1:
n
b v >
1
.
If
1 1
v b = , bidder 1s net payoff = 0
1
>
n
b v
(because bidder 1 wins the auction, gets the prize, and pays the second highest bid).
If bidder 1 bids ) , (
1

n
b b , his payoff =
n
b v
1
.
Therefore, bidder 1s net payoff is the same for all bids
n
b b >
1
.
If he bids
n
b b <
1
, bidder 1s net payoff = 0 (since he loses the auction).
Therefore, bidder cannot do better than bid
1 1
v b = when
n
b v > .

3. Case 2
n
b v
1
.
If
1 1
v b = , bidder 1s net payoff = 0
(because he loses the auction or wins the auction and pays exactly his valuation of the
object).
If ) , (
1 n
b b , bidder 1s net payoff = 0 (since he loses the auction).
If
n
b b
1
, bidder 1s net payoff = 0
1

n
b v
(because he wins the auction, but pays a price that exceeds his valuation of the object).



Observation. Both the first-price auction and the second-price auction belong to the class of
auctions under consideration.


Question: Can we say anything about which auction procedure the seller prefers?


6

REVENUE EQUIVALENCE THEOREM:
With risk neutral bidders, all auctions in the class of auctions under consideration yield the same
expected revenue for the seller. The sellers expected revenue is:
dv v F v F v F v n
n
v
v
1
)] ( [ 1 ) ( ) (

+

} { . (16)

Proof. From equation (8), the sellers expected revenue from buyer 1 is:

1
P = ) ( ) (
1 1
v dF v P
v
v

= ) ( ] ) ( [ ] ) ( [
1
1 1
1 1
1
v dF dv v F v F v
n
v
v
n
v
v
} {


(17)


= ) ( ] ) ( [ ) ( ] ) ( [
1
1 1
1
v dF dv v F v dF v F v
n
v
v
v
v
n
v
v


. (18)


Integration by parts reveals:
) ( ] ) ( [
1
1
1
v dF dv v F
n
v
v
v
v


=
1
1
1 1
1
1
] ) ( [ ) ( ] ) ( [ ) (
1
dv v F v F dv v F v F
n
v
v
v
v
n
v
v




= dv v F v F dv v F
n
v
v
n
v
v
1 1
] ) ( [ ) ( ] ) ( [


= dv v F v F
n
v
v
1
] ) ( [ ] ) ( 1 [

. (19)


Combining equations (18) and (19) provides:

1
P = dv v F v F v F d v F v
n
v
v
n
v
v
1 1
] ) ( [ ] ) ( 1 [ ) ( ] ) ( [





= dv v F v F v F v
n
v
v
1
] ) ( [ 1 ) ( ) (

+

} { . (20)

With n bidders, all of whom are treated identically, the sellers expected revenue is:

1
P n = dv v F v F v F v n
n
v
v
1
)] ( [ 1 ) ( ) (

+

} { .

7

Question: What are the properties of the optimal minimum bid or reserve price?

Proposition. Under the maintained assumptions, the (interior) minimum bid ( ) (
R
v b ) that
maximizes the expected return of the seller with reserve value
0
v is defined by:
) (
) ( 1
0
R
R
R
v F
v F
v v

+ = , (21)
and is independent of the number of bidders.

Note. If ) (
R
v b is the minimum bid allowed,
R
v is the smallest valuation for which a bidder
will participate in the auction

Proof.
1. Given the equilibrium bidding strategy ) (v b , the seller who sets a minimum bid ) (
R
v b will
retain the object (of personal value
0
v ) with probability
n R
v F )] ( [ .

2. Thus, using equation (16) to capture the sellers expected revenue, P , the sellers expected
net return from the auction is:
dv v F v F v F v n v F v G
n
v
v
n R
R
1
0
] ) ( [ ] 1 ) ( ) ( [ )] ( [

+ + . (22)
3. Maximizing the expression in (22) with respect to
R
v provides:

1 1
0
)] ( [ ] 1 ) ( ) ( [ ) ( ] ) ( [

+ =

n R R R R R n R
R
v F v F v F v n v F v F v n
v
G
= 0. (23)

Equation (23) implies:
0 1 ) ( ) ( ) (
0
= +
R R R R
v F v F v v F v , or

) ( 1 ) ( ) (
0
R R R R
v F v F v v F v + = . (24)

Equation (24) implies:
) (
) ( 1
0
R
R
R
v F
v F
v v

+ = . (25)


Observation. The seller always sets a reserve bid above his own private valuation of the object.

With some probability, the seller retains the object, even though some buyer would be
willing to pay more than ) (
R
v b for the object. However, the minimum bid requirement
limits excessive shading of bids.


8

ILLUSTRATION OF THE EFFECT OF A RESERVE PRICE

Assumptions:
1. Risk-neutral bidders.
2. Uniform distribution for valuations on ] 1 , 0 [ v .
3. 0
0
= v (the object has no value to the seller).

Case 1. Optimal Reserve Price Instituted.
Equation (21) implies
R
v is determined by

) (
) ( 1
0
R
R
R
v f
v F
v v

+ = . (26)
Because 0
0
= v , equation (26) implies:

R
R
R
R
v
v f
v F
v =

= 1
) (
) ( 1

2
1
=
R
v .
From equation (16), when 2 = n , the expected revenue of the seller is:
dv v v v ] 1 [ 2
1
2 / 1
+

(27)
=
(

=

1
2 / 1
1
2 / 1
2
1
2 / 1
2 2 ] 1 2 [ 2 dv v dv v dv v v (28)

=
(

=
(


4
1
1
12
1
3
2
2
2
1
3
2
2
1
2 / 1
2
1
2 / 1
3
v v

=
12
5
12
9 14
4
3
6
7
4
3
12
7
2 =

= = |
.
|

\
|
. (29)
Case 2. No Reserve Price ( ______0 =
R
v ).
Again, from equation (16), the expected revenue of the seller is:

= dv v dv v v v ] 1 2 [ 2 ] 1 [ 2
1
0
1
0
= +

(30)
=
(

=
(
(

1
0
2
1
0
3
2
1
3
2
2
2
2 2
1
0
1
0
v v dv v dv v
=
12
5
12
4
3
1
6
1
2
2
1
3
2
2 < = =
(

=
(

. (31)

9

EXTENSIONS

1. Risk-Averse Bidders

Proposition. When bidders are risk averse, the sellers expected profit is higher under the first-
price auction than under the second-price auction.
Explanation:
1. When he shades his bid, a bidder increases the chances of a big win, but also increases the
chances of no win.
2. This trade-off becomes less attractive to a bidder as his degree of risk aversion increases.
3. Consequently, there is less shading of bids under the first-price auction when bidders are
risk averse than when they are risk neutral.
The reduced shading of bids increases the attraction of the first-price auction to the seller
relative to the second-price auction, where truth-telling remains a dominant strategy.

2. Common Value Setting (Winners Curse).

v = true value of object to each bidder.



i
v = bidder i s estimate of

v .

i
v =
i
v +

,
where
i
is the realization of an independent and identically distributed random variable
with mean zero.


Observation. Each individuals estimate is unbiased. However, the highest estimate (the
winners estimate) is upward biased.

Proposition. In the common value setting, the sellers expected profit is higher under the
second-price auction than under the first-price auction.

Explanation.
1. In first-price auctions, bidders shade their bids more in the common value setting than when
their valuations are private and independent.
2. The increased shading of bids arises to counteract the winners curse.
3. The increased shading of bids under the first-price auction leads the seller to prefer the
second-price auction.

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