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Auctions: A Sampling of Techniques

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1993
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FOR COUNTRIES making the transition from centrally planned to market-based economies, auctions offer many advantages. There are a variety of auction techniques, and the choice of an appropriate format depends on the item or items being auctioned and on individual country circumstances.

In many parts of the world, countries are trying to establish and improve market-oriented institutions. This effort is particularly evident in the transforming economies of Eastern Europe and the newly emerging states of the former Soviet Union. The use of appropriate auction techniques can determine market-clearing prices where markets may not otherwise exist. It can also help acclimate the business sector to operating in a world of market-determined and changing prices and efficiently allocate the items being auctioned.

Numerous auction formats are used throughout the world. Is one better than the other? Unfortunately, there is no unambiguous answer to this question. The most appropriate technique will depend on the asset auctioned and on individual country circumstances. For countries seeking to adopt auctions, therefore, the basic auction formats are worth exploring. This article explains these formats, drawing on the existing—and mostly theoretical—literature. It also assesses alternative auction techniques for pricing and allocating various financial instruments, using government securities, refinance credit, and foreign exchange as examples.

In practice, techniques used to auction similar items vary considerably across countries, both industrial and developing. Several countries auctioning government securities have awarded them at whatever price was bid (e.g., France, Germany, Japan, and the United Kingdom), while others have charged a single market-clearing price (e.g., Denmark and Switzerland). Italy and Mexico have recently auctioned government securities using both uniform and multiple price techniques. The US Treasury is currently experimenting with uniform-price auctions for some government securities and conducting discriminatory auctions.

Types of auctions

Actions may be used for a single item or unit, such as artwork and construction contracts, or for multiple units of a homogeneous item, such as gold and Treasury securities. While this article deals primarily with auctions of multiple, homogeneous assets, the theoretical literature frequently assumes that a single unit is being auctioned. Accordingly, the definitions used here will apply to both single and multiple unit auctions.

English or ascending-price auction. This type of “open” auction is the most familiar. Starting with a low first bid or a specified reservation price—a price below which the item will not be sold—the auctioneer solicits increasingly higher bids. With a single item, the process continues until the item is sold to the highest bidder. In an auction involving multiple units, the process continues until a price is reached at which total demand matches the fixed amount supplied.

Dutch or descending-price auction. Another kind of open auction owes its name to the technique used in the Netherlands to auction produce and fresh flowers. The bidding starts at a high price that is progressively lowered until a buyer claims the item by shouting “mine!”—or, in more modern times, by pressing a button that stops an automatic clock at an acceptable price. When multiple units are being auctioned, there are normally more takers as the price declines; the process continues until a price is reached whereby the fixed amount supplied is matched by total demand. Dutch auctions have been used for refinance credit in Romania and for foreign exchange in Bolivia, Ghana, Jamaica, and Zambia.

First or discriminatory-price auction. This is a sealed-bid rather than an open auction. The term “first price” commonly applies when a single item is being auctioned. In such cases, the highest bidder is awarded the item at a price equal to the amount bid. When multiple units are auctioned at the same time, the procedure is called a discriminatory auction. The sealed bids are sorted from high to low, and items are awarded at the highest bid prices until the supply is exhausted. Thus, the auction discriminates between bidders in the sense that they can pay different prices according to the amount they bid. Confusion sometimes arises because, in the financial community, this auction format is frequently referred to as an English auction; in the United Kingdom, it is called an American auction; it is also referred to as a multiple-price (or in some cases multiple-yield) auction. Discriminatory-price auctions have also been used for refinance credit and foreign exchange.

Second or uniform-price auction. This type of auction is also a sealed-bid auction. When a single item is auctioned, the highest bidder is awarded the item at a price equal to the highest unsuccessful bid (thus the name, second price). The multiple unit extension of the second-price, sealed-bid auction is referred to as a uniform-price or competitive auction, because all winning bidders receive the auctioned items at the same price. Also known as a marginal-price auction and in the financial community as a Dutch auction (giving rise to some confusion in terminology), uniform-price auctions were used in the former Czechoslovakia for refinance credit and in Guinea, Nigeria, and Uganda for foreign exchange.

Double auction. Using this format, both sellers and buyers submit bids, which are then ranked from highest to lowest to generate demand and supply profiles. From these profiles, as illustrated in the example below, the maximum quantity exchanged can be determined by matching sell offers (starting with the lowest price and moving up) with demand bids (starting with the highest price and moving down), although the “equilibrium” price may be indeterminate using this methodology. As an example, suppose four sellers of foreign exchange offer to sell one unit at prices of 100, 200, 300, and 400 units of domestic currency, and four demanders of foreign exchange offer to buy one unit at prices of 400, 300, 250, and 50 units of domestic currency. Supply and demand would match at three units of foreign exchange, but the price would remain indeterminate, falling somewhere between 200 and 250. Romania has used this type of auction.

Auctions also differ according to how each bidder values the item or items on the auction block. Economists customarily distinguish between the “private-value” case and “common-value” case. The first involves objects acquired for personal consumption; there is no primary motive to resell. The bidder, therefore, is willing to pay up to a certain maximum, independent of the valuations of rival bidders. The second refers to objects acquired primarily for profitable resale in secondary markets. In this case, individual bids are predicated not only on personal valuation but also on the valuation of prospective buyers in the common-value case. Under common value, each bidder places the same value on the object—that is, each one tries to estimate the object’s ultimate worth on the basis of the same standard. This common value may be an unobservable variable at the time of the auction, as is the case when a government security is purchased to be resold in the secondary market.

Auction theory

In any attempt to evaluate different types of auctions, the nuances and details surrounding the choice of any particular auction format are exceedingly important.

The bidder’s perspective. Although bidders may have quite different characteristics, the theoretical literature often assumes that auction participants are homogeneous. Assuming that bidders are identical and will all focus on maximizing profits (in the parlance of the literature, risk-neutral and symmetric) and that only one item is being auctioned, the Dutch auction is strategically equivalent to the first-price, sealed-bid auction. No relevant information is revealed until the conclusion of the auction, when it is too late for any bidder to act on or change a bid. The English and second-price auctions are equivalent under the private-values assumption, but not under the more realistic common-value assumption. (In an English auction, new information is obtained from the bidding process; this is not the case with a second-price auction.)

“Recognizing the winner’s curse, bidders in first-price auctions will tend to bid less aggressively and shade their bids below their true estimate.”

A particularly important consideration from the bidders’ perspective is the “winner’s curse,” or the trade-off between the probability of winning the auctioned item and the expected profit from winning, when all other participants appear to be estimating a lower market value. In effect, winning bidders are faced with the realization that their assessment of value exceeded that of all the other bidders. And being aware of this possibility, bidders in, for example, a first-price auction are likely to “shade” their bids in an effort to move closer to the market consensus. In such situations, bidders may also devote their resources to assessing rival bids and information in an effort to bid closer to this consensus.

The seller’s perspective. The theoretical literature demonstrates that under the assumption of private value, all four basic auction types can be shown to yield the same expected price and revenue to the seller when bidders are risk neutral and symmetric. This “revenue equivalence theorem” implies that the particular auction format chosen by the seller is not crucial because each format yields, on average, the same payoff.

But the revenue equivalence theorem does not necessarily hold under the common value assumption. It can be shown that the expected revenue from selling a single object (but not necessarily multiple objects) in the four auction formats can be ranked from highest to lowest, as follows: the English ascending-price auction; the second-price, sealed-bid auction; the Dutch auction and the first-price, sealed-bid auctions (tied). It is conjectured that this ranking tends to carry over in a multiple-object environment.

The rankings clearly illustrate the advantage of increased information. The English auction reveals information about rival bidder valuations and permits a dynamic updating of the personal valuation by individual bidders, leading to more aggressive bidding. In comparison, recognizing the winner’s curse, bidders in first-price auctions will tend to bid less aggressively and shade their bids below their true estimate. Similar reasoning applies to the strategically equivalent Dutch auction. In contrast, in the second-price (uniform) sealed-bid format, the winner pays the bid of the next highest bidder. Bidders in these auctions tend to raise their bids above what might be offered in a first-price auction bid, secure in the knowledge that they will not be disadvantaged if rival bidders’ valuations are much lower.

Efficiency. The theoretical literature on auctions emphasizes economic efficiency less than other aspects of the various auction formats, such as their revenue-generating potential. The available evidence—both theoretical and empirical—indicates that auctions, in the absence of distortions, function efficiently in a range of circumstances, so that resources accrue to those that value them most highly and sellers achieve the maximum value for their assets. In addition, the auction mechanism can achieve this objective more effectively than alternative trade arrangements, such as price setting by the seller or negotiation between buyer and seller.

Collusion. The extent to which incentives to collude vary under different auction formats is of practical concern in deciding on the type of auction mechanism to implement. All auctions are susceptible to collusive behavior in one way or another, but the incentive for collusion varies under different auction formats.

A basic hypothesis, first formulated by economist Walter Mead in 1967, is that ascending-bid formats are more susceptible to collusion than sealed-bid auctions. This belief may explain the popularity of sealed bidding, even though the ascending bid format has superior revenue-generating potential. The open format is more conducive to collusive agreements because adherence can be readily monitored and because any “ring” member attempting to exploit the pact by a side deal would effectively negate the ring and restore the auction to a competitive footing.

Sealed-bid auctions, in comparison, are vulnerable to collusion between the auctioneer and one or more bidders or between the auctioneer and the seller, because fraudulent activity by the auctioneer is easier to hide when bids are sealed and not revealed to others. This format is, however, less prone to collusive rings, as sealed bidding tempts the participants in any conspiracy to bid just above the agreed price, effectively dissolving the cartel. This result also holds for the Dutch format, even though it is an open—rather than a sealed-bid—auction. For example, when one item is auctioned, the first bidder to defect from the ring ends the auction. Theoretically, the ranking from (potentially) most to least collusive is an English auction; a uniform, second-price auction; a discriminatory, first-price auction; and a Dutch auction.

Applications

Government securities. Considerable debate has focused on the question of the appropriate auction format for selling government securities. The theoretical analysis assumes that bidders demand only one indivisible unit of the commodity being auctioned. But in the case of government security auctions, bidders frequently submit bids for multiple units. They may also be permitted to submit multiple bids, in effect demanding differing quantities and prices at the same auction. In such circumstances, theoretical models offer only limited insight.

One major argument in favor of a uniform second-price auction rests on the belief that this type of auction will probably increase revenue to the government because the winner’s curse is muted, leading to more aggressive bidding. The magnitude of the increase may be small, however, and economic efficiency may be a more appropriate goal than revenue maximization. Another often-cited advantage is that, because the winner’s curse is muted, participation and competition will increase. A third advantage is that it can promote economic efficiency by reducing the amount of resources that would otherwise be devoted to assessing rival bids and information, an activity that may be considered excessive when it serves only to redistribute wealth among bidders and therefore constitutes a “dead-weight” loss from a societal perspective. A final consideration is that a uniform, second-price auction may be easier to implement. A major disadvantage of uniform price auctions, however, is that they are more prone to collusion than discriminatory auctions.

Any recommendation favoring a particular type of auction must be country-specific. If a fairly active competitive market exists, a uniform price auction may be appropriate, since the threat of collusion is minimal, and society could gain from devoting fewer resources to assessing rivals’ actions. Revenues to the government may also increase, although estimates indicate that such increases may be small (as in the case of the United States, for example).

If the market in a particular country is thin and subject to collusion, a discriminatory auction would seem more appropriate. In an immature market, the discriminatory format may be useful initially because it encourages information gathering that may in turn help support market development. But in the absence of concerns about collusion, a later shift to a uniform format would be desirable. To increase competition and safeguard against monopoly positions, measures—such as lowering barriers to entry—should be taken.

In some situations, English auctions might also be considered (recall the earlier discussion under “the seller’s perspective”), particularly in cases where it is possible to run a centralized open-outcry auction, for instance, in a small country where all auction participants could gather in one location in the capital city.

Refinance credit. In general terms, refinance credit represents direct lending by a central bank, usually to the financial sector but sometimes directly to ultimate users. Lending to the financial sector can be for the specific purpose of implementing monetary policy by, for example, providing liquidity to commercial banks to meet specified monetary targets. It can also represent lending by the central bank to provide funds to the financial sector for on-lending directed to targeted activities.

Auction techniques are one way to allocate refinance credit. They have the advantage of tying the refinance rate to market conditions and improving efficiency. A potential added benefit is that auctions may improve transparency while lessening discretion in the allocation of credit. Auctioning refinance credit may, however, subject the seller to risks because payment for the auctioned item or items may not be made in advance, as it is with government securities. Clearly, the institutional setup of any auction must ensure the quality (such as the credit risk) of the bidders to avoid problems such as adverse selection, with the riskiest bidders always bidding the highest prices. A difficult situation could arise, for example, if those demanding refinance credit have strong incentives to seek credit at higher prices because they themselves hold nonperforming assets and are ready to go under.

Foreign exchange. Countries adopting market-related arrangements for their exchange rate have been confronted with two basic choices: operating an interbank type of market within the private sector, which may, in addition to commercial banks, include other licensed foreign exchange dealers; or developing an auction system under which foreign exchange is surrendered to the central bank for auction to the highest bidders.

Under the auction system, countries have used different techniques that in general are based either on discriminatory pricing (including a Dutch auction) or on a uniform pricing approach. A possible difficulty with discriminatory pricing is that it may discourage potential participants from entering the market, or, because of the winner’s curse, impede more aggressive bidding. (Some countries have argued that this result can be advantageous in deterring speculators or at least ensuring that they pay the full price for their bids.) Other problems include determining the appropriate exchange rate to be used for transactions outside the auction (e.g., for government transactions and customs purposes). Uniform pricing would resolve some of these difficulties and more closely match the functioning of private foreign exchange markets. But the interbank approach has the advantage of involving less government control over the availability of foreign exchange in the private sector, as opposed to auctions, which rely on the government to specify the quantity of exchange available—perhaps after the government’s own needs have been met.

The double auction, with both sellers and buyers submitting bids, is less restrictive because the government has less discretion in determining the amount of foreign exchange to be auctioned. In addition, the double auction involves the private sector on both the supply and demand sides, a technique that is, in a sense, implicit in the interbank market when brokers match the supply and demand orders that they receive. But rather than being a continuous market, as an interbank market would be, a double auction is run at discrete points in time, like a fixing session. Such an approach may be appropriate when a country lacks the institutional capacity or experience to operate an interbank market, but some of the flexibility of the interbank approach is desirable. Since the main goal is to encourage trading, not only at the time of the auction but also on a more continual basis, double auctions can be seen as a useful intermediate step. Ultimately, under a floating exchange rate system, governments should work toward the development of an interbank market.

Conclusions

Auctions offer the advantage of simplicity in determining market-based prices in countries where markets may be thin or nonexistent and in allocating the auctioned items efficiently. The appropriate choice of auction format is less clear-cut. This ambiguity stems in part from the difficulties in applying theoretical results to real world settings and in part from the importance of individual country circumstances.

Our review of auction techniques suggests that uniform, second-price auctions, because of their administrative simplicity, economic efficiency, and revenue-enhancing potential, are perhaps the most widely applicable format. The ascending-price, English auction may be preferred for auctioning government securities or refinance credit. But unless individual country circumstances provide for a bidding forum conducive to the open-outcry format, this mechanism is technically infeasible. In addition, the English auction is, potentially, the format most prone to collusion and should be avoided if prevailing institutional arrangements are conducive to side deals. When collusion is a concern, discriminatory auctions should be considered. Most important, however, auctions should be conducted competitively in all formats with stringent safeguards against monopoly positions.

For a more complete discussion, see “Auctions: Theory and Applications” by the authors in IMF Staff Papers, September 1993.

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