Risk aversion and auction design: Theoretical and empirical evidence

Auctions are inherently risky: bidders face uncertainty about their prospects of winning and payments, while sellers are unsure about revenue and chances of a successful sale. Auction rules influence the allocation of risk among agents and the behavior of risk-averse bidders, leading to a breakdown of payoff and revenue equivalence and a heightened significance of auction design decisions by sellers. In this paper, we review the literature on risk aversion in auctions, with an emphasis on what can be learned about auction design from theoretical modeling and empirical studies. We survey theoretical results relating to the behavior of risk-averse agents in auctions, the comparison of standard auction formats in the presence of risk aversion and implications for auction design. We discuss standard and more recent approaches to identifying risk preferences in empirical studies and evidence for the significance of risk aversion in auction applications. Finally, we identify areas where existing evidence is relatively scant and ask what questions empirical research might ask given the theory and where further theoretical research may be beneficial given existing empirical results.     

The role of Internet auctions in the expansion of B2B markets

In the wake of the advent of the World Wide Web, businesses are scrambling to take advantage of changes in their markets. While the consumer side of the Web explosion has been much touted, it is the business-to-business (B2B) market that has quietly surpassed expectations. An important business model that is responsible for this new market expansion is the Internet or Web auction. Businesses are adapting traditional auctions to the instantaneous “real-time” advantage of the Net to reach new markets that were previously cost-prohibitive by reducing transaction costs. Advantages such as the size and scope of the audience are giving Internet auctions a major role in the emerging global economy. This article examines the enormous impact of Internet auctions on B2B markets. We look at the kinds of auctions being conducted and their relevance to emerging business paradigms. We examine the circumstances under which you choose to conduct Web auctions and their impact on pricing mechanisms, information asymmetries, and channel relationships.     

Market Mechanism Choice and Real Estate Disposition: Search Versus Auction

We propose a model of mechanism choice in the disposition of real estate assets where we consider two alternatives: a search market and an auction. Within the search framework, we derive an equilibrium whereby buyers incur search costs and sellers incur holding costs for the period during which the property is not sold. In the auction alternative, the seller joins an existing pool of sellers in undertaking a multiple–object auction and pays a commission upon sale. Buyers and sellers freely choose their mechanisms, which in equilibrium are optimal given each group's conjectures about the mechanism choice of their counterpart. In equilibrium, an agent cannot benefit from deviating from his choice and each agent's beliefs are consistent with the equilibrium outcome. It is shown that (a) buyers with high search costs will choose auctions because the auction payoff imposes an upper bound on buyers' gains from search, and (b) prices at auctions will be higher. Using vacant lot sales data and a method–of–moment estimator which accounts for the presence of an endogenous discrete mechanism choice variable, we estimated a hedonic regression to detect the price effect. It was determined that, on average, lots sold for $1.44 per square foot more in auctions than in the search market, as predicted by our model.     

Spectrum auctions in India: lessons from experience

Spectrum auctions have been used with significant success in many developed countries. From a regulatory and policy perspective, spectrum auctions ensure the efficient use of spectrum by allocating it to those entities that value it most, while also generating revenues for governments. But auctions may lead to unexpected outcomes due to unanticipated problems with their design leading to unexpected bidder behavior such as collusion and over-bidding. The key challenge before regulatory agencies is to design auctions in such a way as to meet the objective of fostering competition while at the same time ensuring that bidders can effectively use the spectrum for their business. While India was one of the early adopters of spectrum auctions, its success in service provision has been low. This paper critically examines issues in auction design that contributed to this delay and reviews the key elements in the design process namely a coherent regulatory framework, choice of service areas, flexibility for service area consolidation, standards and their role, convergence, managing public service regulation and managing defaults. The paper compares the handling of these elements in auctions in the United States (US), United Kingdom (UK) and Australia with the objective of drawing lessons for Indian policy makers.     

Mechanism choice and the buy-it-now auction: A structural model of competing buyers and sellers

A striking feature of many online sales platforms is the coexistence of multiple sales mechanisms. Items on eBay, for instance, are frequently offered through auctions, posted prices, and buy-it-now auctions. In this article, I study how this mechanism multiplicity influences the welfare of buyers and sellers. I specify and estimate a structural model of mechanism choice in online markets, in which I consider both sides of the market: On the demand side, buyers' choices among available listings are equilibrium outcomes of an entry game. On the supply side, sellers make equilibrium decisions when choosing sales mechanisms and prices. I estimate this model using data from sales of baseball tickets on eBay and calculate consumer and seller rents in three markets: the actual market with all three sales mechanisms and two counterfactual markets with auctions and fixed prices or only fixed-price listings, respectively. I find that the addition of auctions to fixed-price markets hurts sellers and risk-averse buyers but benefits risk-neutral buyers. Additionally, the consumer surplus increases when buy-it-now auctions are offered but the seller surplus is reduced further. I discuss the intuition for the cause of this result.     

A Dynamic Model of Auctions with Buy‐It‐Now: Theory and Evidence

In the ascending‐price auctions with Yahoo!‐type buy‐it‐now (BIN), we characterize and derive the closed‐form solution for the optimal bidding strategy of the bidders and the optimal BIN price of the seller when they are both risk‐averse. The seller is shown to be strictly better off with the BIN option, while the bidders are better off only when their valuation is high enough. The theory also implies that the expected transaction price is higher in an auction with an optimal BIN price than one without a BIN option. This prediction is confirmed by our data collected from Taiwan's Yahoo! auctions.     

NON‐COOPERATIVE ENTRY DETERRENCE IN LICENSE AUCTIONS: DYNAMIC VERSUS SEALED BID*

We examine the impact of potential entry on incumbent bidding behavior in license auctions, in both dynamic and sealed bid formats. Unlike sealed bid auctions, dynamic auctions reveal information about the identities of potential winners and allow bidders to revise their bids. This helps incumbents to coordinate their entry deterrence efforts. If entry is sufficiently costly for each incumbent, only the dynamic auction has an equilibrium where entry is deterred for sure. Numerical calculations suggest that, regardless of how costly entry is for each incumbent, sealed bid auctions can generate a higher probability of entry as well as a more efficient allocation.     

Market Coupling and the CWE Project

The article copes with the ongoing effort to establish implicit auctions to allocate transmission capacity on cross-border interconnectors in the power grid. By the means of implicit auctions (in contrast to explicit auctions), cross-border capacities are included in the clearing of local power exchanges. Concerning the day ahead auction, ‘market coupling’ plays an important role. Market coupling connects (formerly often national) electricity markets, simplifying cross-border trade. One of the main drivers of market coupling projects is the pursuit of European market integration i.e. allowing for convenient cross-border trade. The other reason is the perception that explicit auctions of transmission capacity (in addition to energy auctions which are often performed later) do sometimes lead to sub-optimal results. The objective function of market coupling is the maximisation of total welfare of all connected markets. Further to the explanation of different market coupling models (also regarding capacity calculation), the current development in Europe is wrapped up—including the CWE market coupling (Central Western Europe) project. The CWE market coupling is announced to start in fall 2010, coupling the day-ahead electricity markets of Belgium, France, Germany, Luxembourg and the Netherlands.     

Relationship stability, trust and relational risk in marketing channels: Evidence from China

This paper provides an integrated framework for examining effects of relationship stability and trust on relational risk and for exploring the moderating effects of guanxi on the relationships between trust and relational risk in marketing channels. The framework is tested with 225 dyads of questionnaires about buyer-supplier relationships in the Chinese household appliances sector. The results indicate that relationship length and dyadic solidarity can reduce the relational risk perceived by buyers through goodwill trust in their suppliers, but can increase the perceived relational risk through trust in their competence. Guanxi helps to weaken the positive relationship between a buyer's trust in suppliers' competence and its perceived relational risk, and dyadic solidarity can directly lower relational risk. This paper makes clear that buyers locked in a stable relationship will face relational risk, and it further identifies the specific variables which impact on the relational risk and the paths from which relational risk comes.     

Do formal contracts and relational governance function as substitutes or complements?

Relational exchange arrangements supported by trust are commonly viewed as substitutes for complex contracts in interorganizational exchanges. Many argue that formal contracts actually undermine trust and thereby encourage the opportunistic behavior they are designed to discourage. In this paper, we develop and test an alternative perspective: that formal contracts and relational governance function as complements. Using data from a sample of information service exchanges, we find empirical support for this proposition of complementarity. Managers appear to couple their increasingly customized contracts with high levels of relational governance (and vice versa). Moreover, this interdependence underlies their ability to generate improvements in exchange performance. Our results concerning the determinants of these governance choices show their distinct origins, which further augments their complementarity in practice. Copyright © 2002 John Wiley & Sons, Ltd.     

Sorry Winners

Bidders who receive both “common-value” and “private-value” signals about the value of an auction prize cannot fully infer their opponents’ information from the bidding. So bidders may overestimate the value of the prize and, subsequently, regret winning. When multiple objects are on sale, bidding in an auction provides information relevant to the other auctions, and sequential auctions are more vulnerable to overpayment and winners’ regret than are simultaneous auctions. With information inequality among bidders, the seller’s revenue is influenced by two contrasting effects. On the one hand, simultaneous auctions reduce the winner’s curse of less informed bidders and allow them to bid more aggressively. On the other hand, sequential auctions induce less informed bidders to bid more aggressively in early auctions to acquire information.      

Entry and Bidding in Common and Private Value Auctions with an Unknown Number of Rivals

In many procurement auctions bidders do not know how many rivals they face at the time that they incur the cost of preparing their bids. We show in a theoretical model that regardless of whether the procurement is characterized by private or by common values an increase in the potential number of bidders may lead to higher procurement costs. This raises potential policy questions of whether and how entry should be encouraged or limited in public procurement auctions. We use evidence from auctions of construction contracts to estimate the effect of an increase in the pool of potential bidders on entry and auction prices when entry and bidding decisions are made sequentially with no knowledge of the number or identity of the actual competitors.     

Optimal Selling Mechanism,Auction Discounts and Time on Market

This article examines the optimal selling mechanism problem in real estate market using mean‐variance analysis and downside risk analysis. When sellers can choose between accepting the first offer above a reservation price or auctions (waiting an optimal and fixed time), sellers having higher risk aversion choose auctions and wait a fixed time while sellers having lower risk aversion choose an optimal reservation price and wait a random time. Positive auction discounts are compensated by reduced risks, and there exists a connection between liquidity risk and conditional auction discount. More (Fewer) sellers will choose to sell their houses through auctions in a hot (cold) market or when holding cost increases (decreases). When sellers choose auctions, sellers having higher risk aversion who have lower holding cost wait longer and obtain higher sale price. Loss‐averse sellers unanimously choose the mechanism of setting an optimal reservation price.     

An Empirical Analysis of Entrant and Incumbent Bidding in Road Construction Auctions

This paper explores differences in the bidding patterns of entrants and incumbents in road construction auctions. We find that entrants bid more aggressively and win auctions with significantly lower bids than incumbents. The differences in their bidding patterns are consistent with a model of auctions in which the distribution of an entrant's costs exhibits greater dispersion than that of an incumbent's and relations of stochastic dominance in the distributions do not persist for the entire range of estimated costs. We also find that more efficient firms bid, on average, more aggressively and firms with greater backlogs bid less aggressively.     

On Strategic Quantity Bidding in Multiple Unit Auctions

Standard studies of multiple unit auctions generally overlook the strategic role of bidders' quantity decisions. Using a simple equilibrium model of bidding I analyze bidders' incentives to choose quantities in discriminatory and competitive auctions. The main result is that bidders have a stronger strategic incentive to bid for fewer units in competitive auctions. Since under competition a bidder pays the lowest accepted price for each unit she gets, she may benefit from dropping her quantity to let lower-valuing bidders enter the set of winners. This prediction is consistent with empirical observations from foreign currency and spectrum auctions.     

Governance and game theory: When do franchise auctions induce firms to overbid?

The use of auctions as an instrument of public policy has been hailed as evidence of the utility and validity of game theory. In this paper, we focus on extreme cases – centrally, spectrum auctions in the UK and Germany in 2000 – to argue that the canonical game theoretic interpretations of firm behaviour in some (highly “successful”) auction outcomes are inadequate, that the economics of governance critique of franchise bidding can be extended to provide a better interpretation, and that under specified conditions, notably high uncertainty, policy-makers should design franchise auctions to avoid overbidding, rather than attend to the more conventional challenge of underbidding.     

Auction versus Negotiated Sale: Evidence from Real Estate Sales

We offer a theoretical and empirical comparison of auctions and negotiated sales. We first build a simple model to show that auctions generate a higher relative price than negotiated sales when demand for the asset is strong, when the asset is more homogeneous and when the asset attracts buyers with higher valuations. Using data from property sales in Singapore, we find support for our theoretical predictions. In addition, we find that auctions do not necessarily generate a higher price premium for foreclosed properties than for nonforeclosed properties.     

Sourcing in the global aerospace supply chain using online reverse auctions

This article discusses the use of online reverse auctions to source engineered components in global aerospace supply chains using online reverse auctions and examines the specific case where a long-established U.S. economic cluster supporting large tier-one aerospace companies must compete against globally distributed sources of supply favored by their customers due to unit price savings, principally the result of lower wages. The article also examines if global sourcing practices based on power-based bargaining is an intelligent or effective solution to market pressure demanding lower prices, or whether collaborative problem solving and the creation of knowledge-sharing networks offers greater potential for cost savings and improved long-term supply chain competitiveness. Key factors that contributed to the recent failure of global sourcing initiatives using online reverse auctions are presented. Findings can be generalized to other industries that use online reverse auctions for globally sourcing engineered components that rely on networks of supporting service suppliers to create finished goods.     

Outsourcers’ control mechanisms,vendors’ contract schemas,and project performance in cross-border IT outsourcing: A vendor’s perspective

Relational conflicts are likely to occur in cross-border IT outsourcing between partners with different cultural backgrounds. Extant literature diverges on the role of contract and trust as control mechanisms in managing relational conflicts. Prior studies have examined the effectiveness of the control mechanisms primarily from the outsourcer’s perspective, with little consideration of how vendors interpret outsourcers’ control mechanisms. Based on psychological contract theory, this study addresses the effects of contract-based and trust-based control mechanisms on relational conflicts from the vendor’s perspective and further explores the contingency of the effects on vendors’ psychological contract schemas (transactional contract schema and relational contract schema) towards their relationships with outsourcers. Based on survey data from 180 offshore outsourcing IT projects, the results show that vendors’ transactional contract schema reduces the effect of trust-based control whereas vendors’ relational contract schema strengthens the effect of outsourcers’ contract-based control on relational conflict. Relational conflicts, in turn, exhibit a negative impact on project performance. The findings offer new insights into the role of outsourcers’ contract-based control and trust-based controls in relationship management from a vender’s perspective. The findings also extend the outsourcing governance literature by illustrating the contingency of the control mechanisms on vendors’ psychological contract schemas.     

Role conflict and ambiguity confronting transnational business networkers: Contrasting social stigma and relational risks for Chinese and Western boundary spanners

Our research explores the role conflict, ambiguity and resulting social stigma and relational risks that transnational B2B networkers face when facilitating the formation of new exchange dyads between firms from distinct and distant cultures, i.e. Chinese and Western. We integrate literature from institution theory and role theory to establish the comparative framework. This allows us to explore: (1) what stigma and relational risks guanxi brokers assume when facilitating transnational business connections; (2) if Western brokers encounter similar stigma and negative consequences that threaten their professional standing and the formation process; and, (3) the lessons from both that transnational firms can learn and incorporate into best practices. We conclude our paper with managerial implications and suggestions for further research.