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Auction Theory Basics

1. Bidding and Equilibria in IPV model
2. Revenue Equivalence
3. General Model: Affiliated Values
4. Linkage Principle: Revenue Ranking
Ad Auctions: Sponsored Search

Auctions: The Independent Private Values Model

Basic Auction Environment
Bidders i = 1, ..., n
One object to be sold
Bidder i observes a signal Si F (), with typical realization
si [s, s]. Assume F is continuous.
Bidders signals S1, ..., Sn are independent.
Bidder is value vi(si) = si.
A set of auction rules will give rise to a game between the bidders.

The IPV Model

Two important features of the model:
Bidder is information (signal) is independent of bidder js information (signal).
Bidder is value is independent of bidder js information (i.e. private values).

Vickrey (Second-Price) Auction

Auction Rules:
Bidders are asked to submit sealed bids b1, ..., bn.
Bidder who submits the highest bid wins the object.
Winner pays the amount of the second highest bid.
Proposition 1 In a second price auction, it is a (weakly) dominant strategy to bid ones value, bi(si) = si.
Proof. Bidding bi means i will win if and only if the price is below bi.
Bid bi > si sometimes win at price above value.
Bid bi < si sometimes lose at price below value.

Expected Vickrey Auction Revenue

Sellers revenue equals second highest value.
Let S i:n denote the ith highest of n draws from distribution F.
Sellers expected revenue is
 2:n
E S
.

Open Ascending Auction

Auction Rules:
Prices rise continuously from zero.
Bidders have the option to drop out at any point.
Auction ends when only one bidder remains.
Winner pays the ending price.
With private values, just like a Vickrey auction!

Sealed Bid (First-Price) Auction

Auction Rules:
Bidders submit sealed bids b1, ..., bn.
Bidders who submits the highest bid wins the object.
Winner pays his own bid.
Bidders will want to shade bids below their values.
Well look at two approaches to solving for symmetric equilibrium bidding strategies.

FOC Approach to First Price Auction

Suppose bidders j 6= i bid bj = b(sj ), b() increasing.
Bidder is expected payoff:
U (bi, si) = (si bi) Pr [bj = b(Sj ) bi, j 6= i]
Bidder i chooses bi to solve:
max (si bi) F
bi

n1

b (bi) .

First order condition:

0 = (si bi) (n1)F

n2

b (bi) f b (bi)

1
b0(b1(b

i ))

n1

b (bi)

FOC Approach to First Price Auction

At symmetric equilibrium, bi = b(si), first order condition is:
b0(s) = (s b(s)) (n 1)

f (s)
.
F (s)

Solve using the boundary condition b(s) = s:

R si
b(s) = s

F n1(
s)d
s
F n1(s)

Envelope Approach to First Price Auction

Suppose there is a symmetric increasing equilibrium: bi = b(si).
Then is equilibrium payoff given signal si:
U (si) = (si b(si)) F n1(si).
As b(si) is optimal for i:
U (si) = max (si bi) F n1(b1(bi)).
bi

By the envelope theorem:



d
U (s)
= F n1(b1(b(si)) = F n1(si)
ds
s=si

(1)

Envelope Approach to First Price Auction

Rewriting the envelope formula:
Z
U (si) = U (s) +

si

F n1(
s)d
s.

As b(s) is increasing, bidder with signal s never wins U (s) = 0.

Equating the two representations of U (si):
R si
b(s) = s

F n1(
s)d
s
F n1(s)

(2)

Equilibrium in the First Price Auction

Weve found necessary conditions for symmetric equilibrium.
Verifying that b(s) is an equilibrium isnt too hard.
Also can show that equilibrium is unique.

Expected First Price Auction Revenue

 1:n 
Revenue is high bid b(s ); expected revenue is E b(S ) .
1:n

Rs
b(s) = s

F n1(
s)d
s
F n1(s)

1
F n1(s)

sdF

n1

 1:n1 1:n1

(
s) = E S
|S
s .

Expected revenue is:




 1:n1 1:n1

 2:n
1:n
1:n
E b S
=E S
|S
S
=E S
.
First and second price auction yield same expected revenue.

Revenue Equivalence Theorem

Theorem (Revenue Equivalence) Suppose n bidders have values

s1, ..., sn identically and independently distributed with cdf F (). Then
any equilibrium of any auction game in which (i) the bidder with the
highest value wins the object, and (ii) a bidder with value s gets zero
profits, generates the same revenue in expectation.

Proof of the RET

Consider any auction where bidders submit bids b1, ..., bn, and where
the auction rule specifies for all i,
xi : B1 ... Bn [0, 1]
ti : B1 ... Bn R,
xi() gives probability i will get the object.
ti() gives is payment as a function of (b1, ..., bn).

Proof of the RET

Bidder is expected payoff is:
Ui(si, bi) = siEbi [xi(bi, bi)] Ebi [ti(bi, bi)] .
Let bi () , bi() denote an equilibrium of the auction game.
Bidder is equilibrium payoff is:
Ui (si) = Ui (si, b(si)) = siF n1 (si) Esi [ti(bi(si), bi(si)] ,
where because highest value wins:
Esi [xi(b(si), b(si))] = F n1(si).

Proof of the RET, continued

By the envelope theorem:


d
Ui (s)
= Ebi [xi(bi(si), bi(si))] = F n1(si),
ds
s=si
and also
Z
Ui(si) = Ui(s) +

si

F n1(
s)d
s=

where we use (ii) to write Ui(s) = 0.

Z
s

si

F n1(
s)d
s,

Proof of the RET, continued

Combine the expressions for Ui(si) to get:
Esi [ti(bi, bi)] = siF n1 (si)

Z
s

si

F n1(
s)d
s=

si

sdF n1(
s),

If auction satisfies (i) and (ii), is expected payment given si is:

 1:n1

 2:n

1:n1
1:n
E S
|S
< si = E S | S = si .
Thus expected revenue is constant:
 2:n
.
E [Revenue] = nEsi [is expected payment | si] = E S

Using the Revenue Equivalence Theorem

Many applications of the revenue equivalence theorem.
If the auction equilibrium satisfies (i) and (ii), we know:
Expected Revenue
Expected Bidder Profits (payoff equivalence)
Expected Total Surplus
We can use this to solve for auction equilibria.

The All-Pay Auction

Bidders 1, .., n
Values s1, ..., sn, i.i.d. with cdf F
Bidders submit bids b1, ..., bn
Bidder who submits the highest bid gets the object.
Every bidder must pay his or her bid.

Solving the All-Pay Auction

Suppose all pay auction has a symmetric equilibrium with an increasing strategy bA(s). In this equilibrium, is expected payoff given
value si will be:
Z si
U (si) = siF n1(si) bA(si) =
F n1(
s)d
s
s

So
bA(s) = sF n1(s)

Z
s

F n1(
s)d
s

Other Revenue Equivalent Auctions

1. The English (oral ascending) auction. All bidders start in the auction with a price of zero. Price rises continuously; bidders may drop
out at any point in time. Once they drop out, they cannot re-enter.
Auction ends when only one bidder is left; this bidder pays the price
at which the second-to-last bidder dropped out.
2. The Dutch (descending price) auction. The price starts at a very
high level and drops continuously. At any point in time, a bidder
can stop the auction, and pay the current price. Then the auction
ends.

Common Value Auctions

Generalize the model to allow for the possibility that:
1. Learning bidder js information could cause bidder i to re-assess
his estimate of how much he values the object,
2. The information of i and j is not independent (when js estimate
is high, is is also likely to be high).
Examples:
Selling natural resources such as oil or timber.
Selling financial assets such as treasury bills.
Selling a company.

A General Model
Bidders i = 1, ..., n
Signals S1, ..., Sn with joint density f ()
Value to bidder i is v(si, si).

Affiliated Signals
Signals are (i) exchangeable, and (ii) affiliated.
Signals are exchangeable: s0 is permutation of s f (s) = f (s0).
Signals are affiliated : For any s01 > s001 , s02 > s002 , we have
f (s01|s02) f (s01|s002 )

.
f (s001 |s02) f (s001 |s002 )
i.e. sj |si has monotone likelihood ratio property.
This implies, but is not equivalent to
F (s1|s02) F (s1|s002 )
for all s1. (FOSD)

Examples of the General Model

1. The IPV model.
2. Pure common value with conditionally independent signals.
Example: Si = V + i, where 1, .., n are independent, and
v(si, si) = E[V |s1, ..., sn].
3. Interdependent values, independent signals model.
P
Example: vi(si, si) = si+ j6=i sj , with 1, with S1, ..., Sn
independent.
Note: With interdependent values, i must realize that js bid is informative about is own value. This leads to the winners curse.

Second Price Auction

Look for a symmetric increasing equilibrium bid strategy b(s).
Let si denote the highest signal of bidders j 6= i.
If bi b(si), i wins and pays b(si).
Bidder is problem:
Z
max
bi

s




i
i
i
ESi v(si, Si) | si, S = s b(s ) 1{b(si)bi}f (si|si)dsi

or
Z
max
bi

b1 (bi ) 




i
i
i
ESi v(si, Si) | si, S = s b(s ) dF (si|si)

Second Price Auction

The first order condition for this problem is:
0=

1
b0(b1(bi))





i
1
1
ESi v(si, Si) | si, S = b (bi) b(b (bi)) f (b1(bi)|si)

or simplifying:


bi = b(si) = ESi v(si, Si) | si, max sj = si
j6=i

Failure of Revenue Equivalence Theorem

The RET does not hold in this more general environment.
Basic idea: bidders profits are due to information rents. When
signals are correlated, information rents can be reduced if more
information is used in setting the price.
Example: english auction generates more revenue than a second
price auction.

Linkage Principle Intuition

Bidder profits (rents) are derived from their private information
Statistical linkages align the price more closely to the buyers willingness to pay.
Rents associated with private information fall
Revenue rises

Linkage Principle
Standard auctions A, B with symmetric, increasing eqa bA( ), bB ( )
Let W A(
s, s) denote the expected price paid by bidder 1 if he is the
winning bidder when he receives a signal s but bids as if his signal
were s.
Let W2A(s, s) denote the partial w.r.t. the second argument. That
is, W2 measures how much the expected price increases with increases in the bidders valuation, holding bidding strategy constant.
Theorem 1 Suppose that for all s,
W2A(s, s) W2B (s, s).
Then the expected revenue in A is at least as large as the expected
revenue in B.

Revenue Ranking: First vs Second Price Auction

For the first price (I) auction W I (
s, s) = b1(
s), so
W2I (s, s) = 0.
For the second price (II) auction,
W2II (s, s) > 0,
because conditional on winning by bidding as if his signal is s...
having a higher signal s means that others also have a higher signal...
so the expected price paid (the second highest bid) will be higher.
From the theorem, it follows that the second price auction yields
greater revenue than the first price auction.

Linking Price to Seller Information

If the seller has private information S0 about the object that is affiliated with the signals of the buyers, the seller can increase revenue by
committing to a policy to reveal this information.
Theorem 2 Verifiably revealing information variable S0 raises the
expected price both in the first auction and second price auctions.
Among all policies for full or partial revelation of information, the
policy of full revelation maximizes the expected price.

Linking Price to Seller Information

Interestingly, the policy of full information can be expected to emerge
even when the seller cannot commit to an information policy.
Theorem 3 If a seller must decide, after observing S0, whether
to report it, and if his report is verifiable, then in any equilibrium,
he always reports S0 regardless of the value.
Why would a seller report if s0 is low? Because of affiliation, bidder
signals will be low with or without this information. Revealing will
nonetheless link this information to price.
(If the seller observed s0 *and* bidder signals, then he may prefer
not to reveal.)

Royalties
When the value can be observed by all parties ex-post (even imperfectly), expected revenue is higher when part of the price is a royalty
based on the observed value.
Again, a linkage of available information to final price.