There is more to auctions than meets the eye. If you are going to design markets, make sure you understand how they work.

Two years ago, the Milk Marketing Board was abolished in favour of a co-operative of producers called Milk Marque. At the same time, the arrangement by which milk prices were fixed by a committee of wise men representing producers and processors was replaced by a system of regular milk auctions. As has happened so often in recent years, a malfunctioning capitalist procedure was substituted for a discredited socialist one.

The saleroom auction is in many ways the epitome of market forces. Each of us has our own opinion of what Van Gogh’s Sunflowers is worth. In a dramatic procedure which, like all markets, combines elements of the casino and the ballot box, the auctioneer knocks the picture down to whoever values it most highly.

Examined carefully, the English saleroom auction is a more subtle and sophisticated mechanism than it appears at first sight. The successful bidder doesn’t pay as much as the picture is worth to him. What you pay is only slightly more than the picture is worth to the second highest bidder. The seller therefore gets less than the maximum he might have hoped to extract. But it also means that the auction design has a property which economists have termed incentive compatibility. That means that it pays you to bid honestly, in accordance with your true preferences. So long as all the bidders behave independently – and that is a very important caveat – there is not much to be gained by strategic bidding behaviour.

Contrast that auction with another common type of auction that does not have this characteristic of incentive compatibility – the sealed bid auction, in which each bidder puts a figure on a piece of paper in an envelope. The auctioneer opens the envelopes, and awards Sunflowers to the highest bidder for the sum that he has written on the paper. The shrewd bidder in this auction puts down a figure lower than the one she thinks Sunflowers is worth. After all, she wants to pay just enough to get the picture, not to stump up the limit of her valuation. The bid therefore depends, not just on your valuation, but on your assessment of what other bidders will do. But that assessment will usually be wrong. As a result, the picture will not necessarily go to the person who wants it most, but may go to the most successful player of the auction game.

So the sealed bid auction will not necessarily raise more than the saleroom auction. The saleroom auction attracts honest bids, but does not try to extract the last pound of flesh. The sealed bid auction does try to get every bit of flesh, and in consequence does not attract honest bids.

Now there is a critical difference between an auction of consumer goods, like Sunflowers or old furniture, and the auction of a commercial contract. It is a difference which was first discovered when the US government began the process of auctioning licences for offshore oil exploration.

When Sunflowers comes under the hammer, everyone agrees on what the object is, and the players in the auction differ only in their preferences. Some like Sunflowers, some don’t. But when Esso and Shell put in different bids for a petroleum block, it is not because Esso loves oil while Shell is indifferent. If they both agreed about the objective characteristics of the block, they would both bid the same. They bid differently because each has a different assessment of the block’s oil bearing potential.

That gave rise to what came to be known as the winner’s curse. Sometimes your geologists overestimated the amount of oil that was likely to be there, sometimes they underestimated. On average, these errors would probably cancel out. But the bidding procedure meant that you didn’t get the average and so the errors didn’t cancel. The blocks you won were, necessary, the ones where your geologists had made much higher estimates than anyone else. Too often, the auctions you won were those where your geologists had screwed up.

So oil companies learnt strategic behaviour. You adjusted your bidding to what you thought other companies were doing; only rarely did you put in a bid at something close to what you though an opportunity was worth. The auction system became less efficient, either as a means of allocating exploration rights to the most suitable firm or as a way of obtaining revenue for the government.

Now the winner’s curse doesn’t just apply to offshore oil. It applies to almost any commercial auction process. It was common in the early stages of contracting out of public services. To be sure, the public authority often got some very low bids: but these frequently came from contractors who had simply underestimated what was involved in doing the job. That is why many initially successful contractors were subsequently replaced – either their service was inadequate, or they couldn’t go on doing a proper job at the price they had quoted.

And the winner’s curse is a reason why many mergers, acquisitions and alliances disappoint. Before you congratulate yourself too much on winning that foreign contract to run the local water supply or operate their power station, ask yourself whether your bid was actually better than anyone else’s, or just higher. And when you think that an American acquisition looks attractive, consider whether you are getting it because the company fits better with you than with any other potential partner in the world, or whether you are getting it because you are looking at it through more rose-tinted spectacles than anyone else.

The milk auctions have not worked because the auctions system devised was not incentive compatible. The television franchise auction did not work because it cost too much to bid for there to be an adequate number of players in the auction. There is more to implementing market reforms than is provided by ideological slogans, or can be learnt from an unread copy of Adam Smith. To introduce a market, or to be an effective player in one, you need to understand how markets actually work.

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