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Reality Check: Second-Price Auctions

Search engine ads are sold via second-price auctions rather than first-price. In class, the reason we cited for this preference was that first-price auctions historically resulted in really inconsistent bidding and unstable pricing. Because advertisers want to make margins, they end up bidding below value. This is not the case in second-price, as bidding at value still generates margins since they pay the value of the second bid, which tends to be lower. Therefore, the dominant strategy is to bid at value.

Like many concepts we discuss in class, however, in practice the second-price auctions are not as simple. In the column linked below, writer Esco Strong argues that in reality bidding true values in advertisement auctions is not the dominant strategy. For one, buyers are often working with finite budgets and expected traffic quotas that limit abilities to bid at maximum true value. This, combined with the fact that advertisement slots are not unique and auctions are held repetitively allows buyers to test values and over time learn what they need to bid relative to market to win the auction.

Psychology also factors into the instability of second-price auctions. As we mentioned in class, exchanges in which one person is significantly more powerful in the other doesn’t result in a 100%-0% split in real life, as each party’s perception of the fairness of the deal factors into decision-making. The same is true for these auctions—fairness affects pricing and bidding. On the one hand, sellers understand that their buyers likely aren’t bidding at maximum value and will attempt to manipulate pricing floors to maximize margins. Strong mentions a movement toward dynamically generated pricing floors, which is essentially algorithmically determined sellers’ bids aimed at maximizing value for the seller. Buyers then see this as deceptive—the auction is marketed as second-price to attract buyers under impression that they will pay less than value, then have pricing floors such that they are essentially paying their bids, like a first-price auction.

It’s always interested to see concepts in practice in real life as they often don’t pan out as theorized due to various reasons. The human variable shakes our understanding of exchanges through the psychology of fairness. Extenuating circumstances and business practices affect behaviors by limited allowed actions.

Second-Guessing the Second-Price Auction Model

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