Auctions and Technology Enabled Pricing Strategies

ByBy

Ravi AronRavi Aron

Road Map Market MechanismsMarket Mechanisms

AuctionsAuctionsAuctions and Pricing RisksAuctions and Pricing RisksAuction structure and types Auction structure and types

Market Outcomes in auction marketsMarket Outcomes in auction markets http://www.procuradigital.com/home.asphttp://www.procuradigital.com/home.asp

Q&AQ&A

Going …Going …Gone! On the auctioneer’s block now …On the auctioneer’s block now …

Picture of the first dimpled ballot to be hand countedPicture of the first dimpled ballot to be hand counted A A Chad Chad Collection from Palm Beach county ballotCollection from Palm Beach county ballot

……and recently auctionedand recently auctioned Human KidneysHuman Kidneys Fake paintingsFake paintings Dot-Com shares …Dot-Com shares …

Some items at that are being e-auctioned these daysSome items at that are being e-auctioned these days

Auctions Why Auction Products? Why not simply declare a price and Why Auction Products? Why not simply declare a price and

let the buyers buy the product?let the buyers buy the product? Consider this simple problem - MicroEcon 101 revisited.Consider this simple problem - MicroEcon 101 revisited.

Say, I am the seller of a new Digital device.Say, I am the seller of a new Digital device. Buyers’ willingness to pay for my product is unknown.Buyers’ willingness to pay for my product is unknown. How should I price it?How should I price it?

I Can’t determine the price.I Can’t determine the price. Fortunately, I don’t have to …Fortunately, I don’t have to … … … If I can determine which how different buyers value the If I can determine which how different buyers value the

product.product. An auction helps the seller estimate the structure of demand An auction helps the seller estimate the structure of demand

for her product.for her product.

Product’s Value A basic reason for auctions is A basic reason for auctions is Information AsymmetryInformation Asymmetry..

The value of a product to a buyer is known only to that The value of a product to a buyer is known only to that buyerbuyer

Not all buyers may agree on a product’s value. Not all buyers may agree on a product’s value. There are two kinds of auctions – representing two There are two kinds of auctions – representing two

different ways in buyers value products.different ways in buyers value products. Buyers may value a product differently for different Buyers may value a product differently for different

reasons.reasons. Egyptian thimblesEgyptian thimbles Victorian Snuff boxes …Victorian Snuff boxes …

These auctions are called These auctions are called Private ValuePrivate Value auctions. auctions.

Common Value(s) Auctions The actual value of (any known measure of) the good is the The actual value of (any known measure of) the good is the

same for all buyers.same for all buyers. However, buyers start with different estimates or private However, buyers start with different estimates or private

information about the following aspects of the good:information about the following aspects of the good: Quality of the goodQuality of the good Remaining Economic life of the goodRemaining Economic life of the good Some ‘measure’ of the goodSome ‘measure’ of the good

Oil lease: Buyers disagree on how much oil can be extracted.Oil lease: Buyers disagree on how much oil can be extracted. Quality: Used machinery (DoveBid.com)Quality: Used machinery (DoveBid.com) Broadcast Spectrum: Number of potential subscribersBroadcast Spectrum: Number of potential subscribers

Common and Private Value Auctions In a Common Value auction, buyers can get In a Common Value auction, buyers can get

meaningful information about product’s “true meaningful information about product’s “true value” from other buyers’ bids.value” from other buyers’ bids.

In Private value auctions buyers rarely get any In Private value auctions buyers rarely get any information about the product’s “true value” from information about the product’s “true value” from other buyers.other buyers.

There is a There is a strategic reasonstrategic reason for the existence of for the existence of auction markets in the B2B context.auction markets in the B2B context.

This has to do with the mechanics of auction This has to do with the mechanics of auction markets.markets.

Structure of an Auction

Two factors determine auction market outcomes:Two factors determine auction market outcomes: FormForm in which bids are madein which bids are made The The sequence rulessequence rules for bidding for bidding

Let us look at four basic typesLet us look at four basic types The ascending bid auction (English Auction)The ascending bid auction (English Auction)

Open, calling of bids.Open, calling of bids. Usually Oral, now electronic.Usually Oral, now electronic. Bidders drop out one by one and the one remaining Bidders drop out one by one and the one remaining

bidder wins.bidder wins. Most often used in B2C and C2C.Most often used in B2C and C2C.

Descending Bid Auctions

Descending Bid Auctions (Dutch Auctions)Descending Bid Auctions (Dutch Auctions) Price call opens at a price that is usually set at a Price call opens at a price that is usually set at a

very high value (that nobody would pay).very high value (that nobody would pay). As the bid is continually lowered, buyers may As the bid is continually lowered, buyers may

either call out their bids or lose to a higher bidder either call out their bids or lose to a higher bidder (earlier bidder).(earlier bidder).

Usually exactly one bid which wins.Usually exactly one bid which wins. Can be used to great advantage under certain Can be used to great advantage under certain

conditions by B2B suppliers (we will soon see conditions by B2B suppliers (we will soon see what those conditions are).what those conditions are).

Sealed Bidding First Price Sealed Bid AuctionsFirst Price Sealed Bid Auctions

Each bidder independently submits a single Each bidder independently submits a single sealedsealed bid bid and the highest bidder wins.and the highest bidder wins.

Technically equivalent to the Dutch Auction.Technically equivalent to the Dutch Auction. Used in B2B Auctions (not necessarily electronic).Used in B2B Auctions (not necessarily electronic).

Second Price sealed bid auctionSecond Price sealed bid auction Winner pays the bid value of the Winner pays the bid value of the highest losing bid highest losing bid *.*. Vickrey Auction.Vickrey Auction. In private value auctions, this is equivalent to the In private value auctions, this is equivalent to the

Ascending Bid Auction.Ascending Bid Auction.

Auction Taxonomy

Auction TypeAuction Type Open BiddingOpen Bidding Sealed Sealed BiddingBidding

AscendingAscending EnglishEnglish First PriceFirst Price

DescendingDescending DutchDutch Second PriceSecond Price

VickreyVickrey

View from the Economist’s Room All four types of auctions have the same All four types of auctions have the same

revenue potential from the seller’s point of revenue potential from the seller’s point of view.view.

In reality, what drives the relative distribution In reality, what drives the relative distribution of benefits is the type of the auction and the of benefits is the type of the auction and the extent of risk experienced by the buyer. extent of risk experienced by the buyer.

Sealed bid auctions, especially for high priced Sealed bid auctions, especially for high priced items, tend to favor sellers.items, tend to favor sellers.

Ariba, Commerce One and many other Ariba, Commerce One and many other enablers let the market operator choose the enablers let the market operator choose the type of market mechanism that favors him.type of market mechanism that favors him.

Online and Off Line - What Auction Models Operate? Ascending Bid: Antiques, Artwork, some real estate Ascending Bid: Antiques, Artwork, some real estate

on eBay was sold recently using this method – C2C, on eBay was sold recently using this method – C2C, B2C, B2B. B2C, B2B.

Descending Bid: Descending Bid: Dutch flower auctions, Commodity Dutch flower auctions, Commodity procurement, eProcurement.procurement, eProcurement.

First Price Sealed Bid: sometimes used in B2B First Price Sealed Bid: sometimes used in B2B procurement, mineral rights, real estate Software procurement, mineral rights, real estate Software Project Development contracts,Project Development contracts, etc. etc.

Second Price Sealed Bid: Not a frequently seen beast - Second Price Sealed Bid: Not a frequently seen beast - stamps auctioned by mailstamps auctioned by mail..

Other Kinds of Auctions Reverse AuctionReverse Auction: :

Sellers bid for a buyers’ business. Sellers bid for a buyers’ business. The seller that makes the lowest bid (i.e., The seller that makes the lowest bid (i.e.,

lowest price) – wins the auction. lowest price) – wins the auction. Reverse Auctions too can be run by open or Reverse Auctions too can be run by open or

sealed bidding.sealed bidding. Just as there are open and sealed bid auctions in Just as there are open and sealed bid auctions in

the ‘regular’ auction format – there are open and the ‘regular’ auction format – there are open and sealed bid formats in reverse auctions too.sealed bid formats in reverse auctions too.

There are ascending and descending bid formats There are ascending and descending bid formats in reverse auctions too.in reverse auctions too.

‘‘Regular’Regular’

AuctionsAuctions

Reverse AuctionsReverse Auctions

EnglishEnglish Open, Ascending. Highest bid Open, Ascending. Highest bid winswins

Open, bids go down – Open, bids go down – lowest bid wins. lowest bid wins.

DutchDutch Open, price falls and the highest Open, price falls and the highest bid winsbid wins

Open price rises and Open price rises and highest bid wins highest bid wins

Sealed Bid First Sealed Bid First PricePrice

Sealed highest bidder winsSealed highest bidder wins Sealed lowest bidder winsSealed lowest bidder wins

VickreyVickrey Highest bidder wins and pays the Highest bidder wins and pays the next bidder’s bidnext bidder’s bid

Lowest bidder wins and Lowest bidder wins and receives the next bidder’s receives the next bidder’s bidbid

Multi-Quantity Auctions Suppose there is more than one product being Suppose there is more than one product being

auctioned and there are several bidders. How should auctioned and there are several bidders. How should the auctioneer set the rules?the auctioneer set the rules?

There are two basic kinds of auctions:There are two basic kinds of auctions: DiscriminatoryDiscriminatory Non-discriminatoryNon-discriminatory

The key distinguishing factor is this:The key distinguishing factor is this: Do all buyers pay the same price? (Non-Do all buyers pay the same price? (Non-

Discriminatory)Discriminatory) Does each buyer pay her bid ? (different prices and Does each buyer pay her bid ? (different prices and

therefore discriminatory).therefore discriminatory).

Bid Versus Price Non-Discriminatory: Two flavors:Non-Discriminatory: Two flavors:

All Winners pay the lowest winning bidAll Winners pay the lowest winning bid[20,18,16.5, 15.75, [20,18,16.5, 15.75, 15.015.0, 14.5, 13.75, 12.5, 12.5, , 14.5, 13.75, 12.5, 12.5,

11.0]11.0] All winners pay the highest losing bidAll winners pay the highest losing bid

[20,18,16.5, 15.75, 15.0, [20,18,16.5, 15.75, 15.0, 14.514.5, 13.75, 12.5, 12.5, , 13.75, 12.5, 12.5, 11.0]11.0]

Discriminatory Auctions:Discriminatory Auctions:[[20,18,16.5, 15.75, 15.020,18,16.5, 15.75, 15.0, 14.5, 13.75, 12.5, 12.5, , 14.5, 13.75, 12.5, 12.5,

11.0]11.0][[14.75,13.75,12.9,12.5,12.014.75,13.75,12.9,12.5,12.0,,11.5,10.75,10,9.5,9.011.5,10.75,10,9.5,9.0

,8.75],8.75] What is the optimal strategy for the bidder?What is the optimal strategy for the bidder?

Bidder Behavior and Strategic Implications

Does the choice of auction format impact the Does the choice of auction format impact the outcome?outcome?

Does bidders’ response to certain kinds of Does bidders’ response to certain kinds of uncertainty result in frenzied over bidding?uncertainty result in frenzied over bidding?

Do Reverse Auctions bring about results that Do Reverse Auctions bring about results that are very different from the regular auctions?are very different from the regular auctions?

The Winner’s Curse: A Problem of Overly Aggressive Bidding

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A Variety of Problems

When different goods are sold on a Dutch auction – When different goods are sold on a Dutch auction – there are two kinds of uncertainties that bidders there are two kinds of uncertainties that bidders experience:experience: Which product will competitors select if they win Which product will competitors select if they win

the auction?the auction? How many units will they (competitors) specify How many units will they (competitors) specify

when they place a winning bid?when they place a winning bid? We sold three items in a Dutch Auction and then sold We sold three items in a Dutch Auction and then sold

them separately in an English Auction one after them separately in an English Auction one after another.another.

The results follow.The results follow.

Dutch – Uncertainty Amplifies Winner’s Curse

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Dutch – Uncertainty Amplifies Winner’s Curse

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Dutch – Vs. English

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Strategic Use of Multi-Round Auctions Select a subset of the most aggressive Select a subset of the most aggressive

bidders from a group of bidders and hold a bidders from a group of bidders and hold a sub-auction between them.sub-auction between them.

Will this produce price outcomes different Will this produce price outcomes different from holding a single auction?from holding a single auction?

How are Reverse Auctions impacted by this How are Reverse Auctions impacted by this phenomenon? phenomenon?

Multi-Round Auctions

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Multi-Round Reverse Auctions

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Issues in the design of Industrial Auctions -1

Signaling in Ascending Price AuctionsSignaling in Ascending Price Auctions Two blocks of Auction Spectrums Two blocks of Auction Spectrums

(spectra?) being auctioned.(spectra?) being auctioned.

Blocks 1-5Blocks 1-5 Blocks 5-10Blocks 5-10

Firm AFirm A 18.25 18.25 millionmillion

20 million20 million

Firm BFirm B 20 million20 million 12 million12 million

Ascending Auctions: Ascending Auctions: PunishmentPunishment Strategy Strategy

Issues in the design of Industrial Auctions -2

RochesterRochester IowaIowa

US WestUS West 290,000290,000 00

McLeodMcLeod 300,000300,000 60,00060,000

US WestUS West 313,378313,378 62,37862,378

McLeodMcLeod 00 62,00062,000

Buyer Run Auction MarketsMRO GoodsMRO Goods Manufacturing InputsManufacturing Inputs

Spot SourcingSpot Sourcing Maximum GainsMaximum Gains suppliers will attempt to suppliers will attempt to aggregate.aggregate. Presence of a few large buyers Presence of a few large buyers can easily neutralize seller can easily neutralize seller aggregation.aggregation. Reverse Auction.Reverse Auction.

Buyers can create Buyers can create switching costs to lock in switching costs to lock in suppliers.suppliers. Buyers’ Buyers’ supply risksupply risk can can help suppliers protect profits.help suppliers protect profits. Sealed Bid – Reverse Sealed Bid – Reverse Auction.Auction.

Systematic Systematic OutsourcingOutsourcing

Buyers’ power diminishes as Buyers’ power diminishes as level of customization increases.level of customization increases. Order fulfillment complexity Order fulfillment complexity offers suppliers opportunity to offers suppliers opportunity to customize – “Deep Linking”.customize – “Deep Linking”. Reverse Auction for long term Reverse Auction for long term supply contracts – followed by supply contracts – followed by stable prices. stable prices.

Suppliers are strong.Suppliers are strong. Buyer focus will be on Buyer focus will be on mitigating supply risks.mitigating supply risks. Buyers’ power decreases Buyers’ power decreases with increase in product with increase in product complexity and specificity. complexity and specificity.

Supplier Run Auction Markets

Objective: Set up a bidding war between Objective: Set up a bidding war between buyers.buyers.

Factors that determine outcomeFactors that determine outcome Supply Risks faced by buyers Supply Risks faced by buyers Extent of buyer fragmentation Extent of buyer fragmentation Asset specificity and extent of Asset specificity and extent of

customization required customization required Presence of Reverse AggregatorsPresence of Reverse Aggregators

Supplier Run Auction MarketsMRO GoodsMRO Goods Manufacturing InputsManufacturing Inputs

Spot SourcingSpot Sourcing Buyers are very strong.Buyers are very strong. Presence of Spot Markets can Presence of Spot Markets can weaken seller’s pricing power.weaken seller’s pricing power. Suppliers will prefer to set up Suppliers will prefer to set up ascending auctions / first price ascending auctions / first price sealed bid auction.sealed bid auction.

Buyers’ supply Risks may Buyers’ supply Risks may determine extent of seller determine extent of seller gains.gains. Descending Bid Auctions.Descending Bid Auctions.

Systematic Systematic OutsourcingOutsourcing

Suppliers’ pricing power increases Suppliers’ pricing power increases with extent of customization.with extent of customization. Suppliers will attempt to erect Suppliers will attempt to erect entry barriers for other suppliers.entry barriers for other suppliers. Production capacity constraints Production capacity constraints may be the chief reason for auctions.may be the chief reason for auctions. Large, monopolistic suppliers will Large, monopolistic suppliers will gain disproportionate revenue.gain disproportionate revenue.

Suppliers’ gain increases Suppliers’ gain increases with increase in product with increase in product complexity and specificity. complexity and specificity. Buyer focus will be on Buyer focus will be on mitigating supply risks.mitigating supply risks. Descending bid / First Price Descending bid / First Price Sealed Bid auctions for long Sealed Bid auctions for long term contracts – or multi-tier term contracts – or multi-tier auctions.auctions.

A Summary of Auctions in B2B Markets

MRO GoodsMRO Goods Manufacturing InputsManufacturing Inputs

Spot Spot SourcingSourcing

Buyers are relatively strongest.Buyers are relatively strongest. Reverse Auctions – Sealed Bid Reverse Auctions – Sealed Bid favor buyers.favor buyers. Limits to the effectiveness of Limits to the effectiveness of Forward Aggregators.Forward Aggregators.

Buyers stand to gain more than Buyers stand to gain more than suppliers. suppliers. Buyers Buyers Reverse Auctions Reverse Auctions Suppliers Suppliers Descending Bid Descending Bid Auctions / Multi-tier English Auctions / Multi-tier English Auctions.Auctions. Extent of supply volatility may Extent of supply volatility may determine buyer / seller gains.determine buyer / seller gains.

Systematic Systematic OutsourcingOutsourcing

Suppliers’ pricing power Suppliers’ pricing power increases with extent of increases with extent of customization.customization. Sealed bid reverse auctions for Sealed bid reverse auctions for longer term contracts favors longer term contracts favors buyers.buyers. Opportunity for Forward Opportunity for Forward Aggregators.Aggregators.

Suppliers’ pricing power is greatest.Suppliers’ pricing power is greatest. Descending Bid auctions.Descending Bid auctions. Product Specificity and Product Specificity and Customization determine seller gains.Customization determine seller gains. Opportunity for Reverse Opportunity for Reverse Aggregators.Aggregators.

Summary of Auction Mechanisms

Two types of Auction ContextsTwo types of Auction Contexts Private ValuePrivate Value Common ValueCommon Value

Auction Markets DynamicsAuction Markets Dynamics Bidding Rules: Open Vs. ClosedBidding Rules: Open Vs. Closed Sequencing Rules: Ascending Vs. DescendingSequencing Rules: Ascending Vs. Descending

Why do Auction markets exist?Why do Auction markets exist? Information AsymmetryInformation Asymmetry Strategic Reasons (B2B markets).Strategic Reasons (B2B markets).

Reverse AuctionsReverse Auctions Discriminatory & Non-Discriminatory auctionsDiscriminatory & Non-Discriminatory auctions

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