When Auction Theory Doesn’t Apply
http://www.bbc.com/future/story/20120907-why-we-overpay-at-auctions
This BBC article explores the reasons why consumers do not utilize deeply accepted auction theory in order to maximize their payoff when obtaining an item. The article explains how emotions prevent bidders from using their potential dominant or optimal strategies when bidding for an item, especially on eBay. One of the most interesting statistics found by BBC in this article is that around 50% of eBay auctions end with prices that are greater than the “buy it now” offer. It makes no sense that consumers pay more than the sellers valuation for the item, especially if they are given the option to purchase it at the seller’s valuation initially. Of course, eBay auctions are not the same as sealed-bid, first or second price auctions, which is what we have studied in class. Even so, any type of common sense would indicate that bidders should never bid above their valuations, but this article shows why it happens anyway.
Our studies have shown that bidders have a dominant strategy in sealed-bid, second price auction – bidding their valuation. Even in sealed-bid, first-price auctions, it is optimal for bidders to bid around their valuation, maybe slightly less in order to salvage some payoff. eBay uses an open-bid, first price auction, which is not a format we spent much time covering, but it seems similar enough to a closed-bid auction in that a bidder should never, in any circumstance, bid over their valuation for an item. One of the primary reasons we still see this happening is that consumers often don’t take the time to establish their valuation for an item. They generally have some range of prices in mind, and often extend the range higher and higher as they see other bidders outbid them. In fact, this is the reason that wealthy collectors often send agents to actual auctions – so they don’t get too excited about the items and bid over their valuation. The article also points to the power of the ‘endowment effect’ as a reason bidders sometimes bid above their valuations. The endowment effect causes people to overvalue things that they already own, and because bidders make a connection between their money and the item up for auction, a simulated endowment effect occurs, and they are less willing to give up an item that it seems like they have some type of ownership of. The eBay system also contributes to the willingness of bidders to overbid for an item. When a person becomes involved in an auction, it becomes something of a competition to them, where their goal is not only to get the item, but also the beat the other people who want it. eBay requires no type of confrontation between bidders, and people are more likely to get into disagreements when they are behind screens and not directly in front of their opposition. Our auction theory did not take into account this type of payoff – beating out the others who want the item – and to some people, it is worth losing some monetary payoff to gain this emotional payoff. Our lessons on auction theory should help prevent us from making these types of mistakes when we inevitably become involved in some auction, whether it be on eBay or elsewhere.