Understanding Auctions — Part 1: Auction Fundamentals

At Forte, we’re dedicated to creating new economic and creative opportunities for billions of players around the world. To accomplish that, we’re building a community-owned gaming platform using breakthrough technologies and a new business model that presents an opportunity to change the gaming industry forever. And as part of that commitment, we’ve been sharing our research and observations around key principles in economics, how they work in the real world, and how they might work better if rooted in business models that give ownership to all participants — what we call community economics. We want to hear from others who are interested in advancing and building community economies within games. If you’re interested in contributing to this series, we welcome your insights. Reach out to us; we’d love to have you aboard!

Auctions have become a foundational part of our economy and our society, serving as one of the primary mechanisms by which rights and resources are distributed. Auctions bring buyers and sellers together in one place, aggregating liquidity in the process, which is particularly useful for the sale of hard-to-price assets, where buyer interest is otherwise fragmented. And auctions can be designed to optimize for different outcomes — whether it’s offloading inventory quickly, getting the highest price possible, or encouraging repeat bidders in a regular sequence of auctions. As such, we’re dedicating our next series of articles to exploring auctions, how they operate, how they can be abused and how they can be optimized — beginning with this one, which looks at the fundamental principles of auctions and how they’re expressed in different auction types.

What pops into your mind when you think of auctions? You might imagine a gavel slamming down as a work of art is sold to a paddle-waving buyer in an expensive suit. Or maybe your finger poised over your mouse button, hoping to sneak in one last bid before an eBay offer runs out. Or possibly, if you live in the Bay Area, the wild feeding-frenzy that ensues when a half-dozen people want the same clapboard fixer-upper. These are all obvious examples of auctions.

But there are many more, less obvious examples out there. They impact the air you breathe: In California, the right to emit quantities of carbon are auctioned off on a regular basis, generating revenue for the state and tamping down emissions. They shape the way the power grid operates: In Texas, electricity prices are determined by an auction system called the Day After Market, in which power suppliers and buyers bid on “blocks” of energy to be consumed over the subsequent 24 hours — which means that in extreme situations, electricity costs can vary wildly on a daily basis, contributing to the chaos this past winter when unseasonably cold weather caused demand for electricity to soar.

Governments use auctions to raise money by selling bonds, to allocate access to valuable public resources (like oil exploration rights and wireless bandwidth) and to hire vendors; and in finance, many securities exchanges operate auctions markets, including the venerable New York Stock Exchange.

The bottom line is that auctions are everywhere, and quietly taking place by the millions, all the time, all around the world. There’s a reason why they’re so common. If you have a good sense of how much an item you want to sell is worth, and a clear idea of the type of buyers who might be interested in purchasing it, a simple list-price sale makes sense.

But for many items — for example, unique objects like artwork or rare ones like collectibles — incomplete information exists about how they should be valued, the buyer community is fragmented and it’s not clear what the market is willing to pay. In these situations, auctions enable transactions to take place in a far more efficient fashion than list-price sales.

By establishing the market price for an item when one doesn’t yet exist, auctions can also serve as a valuable part of the sales lifecycle. An auction can set a starting value for a good when it is first introduced, which can then serve as its baseline price for list sales. (Notably, this is how the NYSE sets the trading price for securities at open every day.)

Auctions can be helpful at the end of a product’s lifecycle as well, allowing sellers to rapidly move inventory of a good that’s being discontinued — something we see in the real world all the time, in the form of “odd lot” and surplus auctions.

Auctioneers are typically looking to maximize the revenues they receive for their goods. Revenue maximization, however, is just one potential outcome for which auctions can be optimized. Another is efficiency, or social welfare, which is maximized when the winning bidder for a given item is the bidder with the highest valuation for that item. Perhaps surprisingly, these two objectives are not always aligned — the auction design that offers the greatest profits to the seller may not necessarily result in the most efficient allocation, and vice versa. The appropriate auction design for any given market or circumstance may therefore differ depending on whether the objective is to optimize for revenues or social welfare. Fortunately, as discussed further below, auctions are quite flexible, offering a wide range of parameters that can be tuned to achieve different outcomes.

Where auctions came from and how they evolved

Of course, not all auctions are the same. They’ve had plenty of time to evolve since their first recorded use in human history, as seen in Herodotus’s 430 B.C.E. account of grooms bidding for brides in Babylon. (These events were unique since the families “auctioning” their daughters sometimes started at a negative price — e.g., I’ll pay you to take her off my hands; however, according to Herodotus, some of the money from popular brides was redirected as bonus dowry for the less appealing brides, ensuring a form of marriage market equity.)

Later, in ancient Rome, auctions became broadly used in commercial trade to liquidate property and by the army to sell plundered war booty. It’s this era that gave us the formal name “auction,” from the Latin word auctio, meaning “an increase” (although, as we will see, not all auctions are conducted in ascending fashion). Rome also saw the occurrence of perhaps the most notable auction in classical history, on March 28, 193 AD, when the Praetorian Guard put the office of Roman Emperor up for bid after killing the previous emperor, Pertinax. Didius Julianus outbid his competitors, offering 25,000 sesterce per soldier, which some have calculated as equivalent to about $6250 in U.S. currency today. The Praetorian Guard was made up of 4,500 men, so a very conservative estimate would put the value of the title of Emperor at $28,125,000. Probably an overvalue, since nine weeks later, he was beheaded by a rival, Septimius Severus, who subsequently seized power for himself.

While auctions in classical times were generally held in public-bid, ascending fashion — with participants openly stating how much they were willing to pay, and counter-bidding with one another in turn — as centuries have passed, the variety of available auction types has increased dramatically. Today, auctions can vary across a wide range of dimensions, which can produce different bidding incentives and strategies, winning prices and potentially, even different winners. For instance, auctions may be either ascending or descending, referring to whether prices are increased until only one bidder remains (ascending), or lowered until the first bidder accepts the prevailing price (descending). Auctions may also be first price or second price: in a first price auction, the winning bidder pays exactly the amount he or she bids, while in a second price auction, the winning bidder pays the next highest bid submitted. Auctions can also differ in the amount of information that is made available to bidders: in an open bid auction, bidders are made aware of the bids submitted by other bidders and can decide whether to exceed the prevailing bid, while in a sealed bid auction, bidders all submit their bids simultaneously and without knowledge of the prices submitted by competing bidders.

Other auction parameters that can be tuned include whether or not a reserve price is set (a minimum price that bids must meet or exceed in order to be considered); whether a mandatory bid increment is established, controlling the amount that a newly submitted bid must exceed the current high bid in order to be considered; and, in the case that many items are being auctioned, whether those items are auctioned sequentially or simultaneously.

Highly sophisticated auctions are sometimes implemented to address unique market circumstances and goals for allocation of auctioned items. This is true of popular examples such as the FCC Spectrum auction and search engine keyword auctions. Most circumstances, however, don’t require such complex auction design — and in fact, increased complexity end up costly to implement, while giving rise to unanticipated incentives and bidder confusion, without providing real advantages for sellers or bidders. In auction design, sometimes simpler is better.

The chart below provides an overview of the major auction types in use:

Each has different pros and cons, and may be more beneficial to sellers or to buyers. But the benefits that all forms of auctions offer to sellers are the following:

• Controlled timeframe for sale: Auctions can often (though not always) give sellers more certainty about when the sale of a product, especially a unique one, will happen, versus simply putting the product out “on a shelf” at a set list price, because listed items may simply never sell. (The caveat to this is that auction time limits can also expire with no bids, or if the seller has a reserve price, none that meet the seller’s reserve requirements.)
• Provide signaling about buyer valuations: Auctions give sellers clarity about how much buyers value an item, for future sales of the same or similar goods, which can also reduce price volatility of the good.
• Some protection against abuse/self-dealing by seller agents: Auction rules and mechanisms are often able to provide transparency about pricing and purchaser traits, helping to make unusual transactions more obvious, thus minimizing the potential for agents to transact with their own preferred buyers.
• Reduce the potential for frontrunning by market abusers: Because auctions aggregate bids and then settle transactions based on a predetermined sequence and rule set, the particular form of market exploitation known as frontrunning (trading ahead of a transaction to soak up some of the value that would otherwise be due to transaction participants) is made harder — even more so in the case of sealed-bid auctions.

Of course, when the conditions under which auctions are run aren’t optimal, auctions may end up no more effective than other market mechanisms. And while auctions are resilient to abuses like front-running, they’re not perfect. They can be impacted by other kinds of abuse, and are also vulnerable to the impact of other extraneous factors that can reduce their efficiency or lower the satisfaction of participants in outcomes.

We’ll explore these in Part II of this series, on optimizing auctions in the face of these exploits and inefficiencies.

Interested in contributing to our Community Economics series? We’d love to hear from you. Comment below or email us at cec@forte.io.

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