Article about online auctions from the Economist
FINANCE AND ECONOMICS
The heyday of the
auction
N E W Y O R K
Internet auctioneers such as eBay may be the
instigators of a revolutionary leap forward in
the efficiency of the price mechanism
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AS AN example of all that is frothy, faddish and
foolhardy about investment in Internet shares, you
might be tempted to choose eBay. Despite its
much-hyped initial public offering, its towering
share price and its multi-billion dollar market
capitalisation, this is a company that made its name
by helping people to buy and sell, for example,
beanie babies, second-hand surf-boards and other
stuff that would otherwise end up as junk. But
while eBay's share price may be crazy, it would be
wrong to dismiss the company as just another
symptom of a mania. There is method in this
madness. Online auctions may be one of the most
valuable innovations wrought by the Internet.
Economists have long recognised the virtues of
auctions. In 1880, Léon Walras, a French
economist, described the entire price mechanism as
an auctioneer, attaching a body to Adam Smith's
“invisible hand”. The “Walrasian auctioneer” would
call out a price, see how many buyers and sellers
there were and, if these did not balance, adjust the
price until demand equalled supply.
But in practice, for most of human history, auctions
have not played a starring role in the price-setting
process. Mostly they have been limited to
agricultural and other commodity markets, fine art
and antiques, and— of increasing importance in
recent decades—some types of financial securities.
Two other forms of price-setting have been
dominant: one-to-one negotiation (haggling); and
the non-negotiable menu of prices offered by seller
to buyer. These two approaches are not bad: the
price mechanism based on them obviously does a
much better job of allocating scarce resources than
do centrally planned systems that eschew prices
altogether.
But each method has important flaws. When there
is a menu, the most that people will reveal about
their demand for a given product is whether or not
they are willing to buy at the listed price. So unless
the seller has, from other sources, an intimate
knowledge of supply and demand conditions, the
price he sets may have highly inefficient
consequences. Moreover, menu prices can be
“sticky”—slow to adjust to changes in the balance
of supply and demand.
One-to-one haggling has the advantages of
interaction and dialogue, which improve the
chances of reaching a mutually beneficial outcome.
But it also carries a big risk: that the seller or buyer
may not be negotiating with the best person (ie, the
one willing to pay the most, or sell for least).
Auctions can overcome these shortcomings by
soliciting a wide range of bids from many people.
And the Internet, thanks to its cheap
interconnection of millions of people, makes
well-functioning auctions far easier. They are now
possible for many goods and services that used to
rely on haggling or menus. And even in markets
where auctions have long been used to set prices,
the Internet can make them much more
sophisticated than ever before.
So far, the leading online auctions are fairly simple,
but highly popular, affairs. Already eBay boasts
2.4m sale-items in 1,627 categories. One reason
for its success, and for that of the auctions more
recently offered by uBid, Amazon, Yahoo! and
others, is that they are entertaining. America is now
full of auction addicts crowing about their latest
success or bemoaning a near miss. Yet the
phenomenon has also introduced useful economic
efficiencies, creating big new markets by bringing
together a large number of participants—the “eBay
community” alone boasts 3.8m members.
Steve Kaplan, an economist at the University of
Chicago, points out that online auctions have a big
economic advantage over traditional online
menu-priced sites, such as that pioneered by
Amazon. Such sites cut out the cost of going to the
shops, and make it cheaper to compare prices with
other retailers. But Amazon's customers are no
better off if it attracts more users. Whereas the
more buyers and sellers turn up on eBay, the better
their chances of getting a good deal, as the auction
becomes deeper and more liquid.
On eBay, auctions are transparent: all bids and
bidders are published. This generates valuable
information for buyers and sellers, though it has one
negative side-effect: it increases the risk of
collusion (often a factor in traditional auctions)
because participants can secretly e-mail each
other, and negotiate side-deals.
But eBay has found elegant solutions to some
potential hazards of auctioning online, notably
fraud. Regular sellers can establish a reputation for
reliable delivery and quality, through a rating and
comment system based on the experience of
customers. Indeed, beefing up such quality-control
functions may be behind eBay's recent purchase of
one traditional auction house, Butterfield's, and
Amazon's link-up with another, Sotheby's.
Needless to say, fixed prices are not going to
disappear. Taking part in online auctions is
time-consuming (and nerve-wracking). Economic
theory suggests they are most useful in particular
circumstances: when there is uncertainty about
what is the right price. This could be for one of two
reasons. Either the value of a product is a matter of
private taste and opinion—such as a Van Gogh
painting or a rare Spice Girls doll. Or the value is
likely to be similar for everyone, but it is not
obvious to the seller what it is—such as a
rail-operating franchise or a radio-bandwidth
licence.
Hammer and tongs
The battle for online-auction business is heating up.
FairMarket is hosting auctions for many e-retailing
sites, including Lycos, ZD Net, CompUSA, and
Cyberian Outpost. And then there is Priceline, a
quasi-auction, which sells airline tickets (and hotel
rooms, mortgages and cars, with more to come) by
inviting customers to submit bids for travel on a
particular day. It has the usual stellar share price.
However, Paul Milgrom, an economist at Stanford,
is sceptical about its long-term prospects, because
it lacks some crucial ingredients. In a genuine
auction, offers are compared and the best one is
taken. With Priceline, you name a price once, and
you either get the item or not: the bidder has limited
information about what is available, and none about
how many other would-be buyers there are, and so
has little chance to get a good deal.
Other sorts of auction may have greater promise.
W.R. Hambrecht, an online investment bank, is
using auctions to sell initial public offerings of
shares. Investors submit secret bids; the price is set
at the highest level at which all the available shares
can be sold; and they are allocated at that price to
everybody who bid that amount or more.
According to Peter Cramton, an economist at the
University of Maryland, many IPOs display classic
signs that shares are being sold too cheaply, and to
the wrong people (ie, not to those who value them
most highly). Typically, there is a sharp rise in price
on the first day's trading, and a huge volume of
shares changes hands.
These are exactly the sorts of problems that can be
solved by an auction, but Mr Cramton suggests
that W.R. Hambrecht's method may be unduly
timid. A normal ascending price auction might be
better. A bigger problem may be that big
investment banks like the old system, which lets
them give IPO shares to favoured clients, who can
sell them at once for a juicy profit. Firms also like
the splash of publicity they get when shares soar
after an IPO; W.R. Hambrecht's recent flotation of
Salon.com, a “website for intellectuals”, was
widely thought disappointing because the shares
did not soar to an instant premium. In fact, this
showed a well-functioning auction: shares had gone
to those willing to pay most for them.
Business-to-business auctions show considerable
promise, and are expected soon to make up most
of the volume of the online market. Because
transactions between businesses tend to be
relatively infrequent, the seller may be uncertain
about the right price. Auctions can tell him. One
online auctioneer, Freemarkets, held auctions
worth over $1 billion in 1998 alone, for materials
and components ranging from plastic moulded
parts to energy.
Business-to-business auctions demand greater care
than consumer auctions. Yoav Shoham of
TradingDynamics, a firm that is developing a wide
range of sophisticated online auctions for
businesses, points out that they usually involve
larger amounts of money, that firms are not seeking
entertainment, and they do not want to jeopardise
any long-term strategic relationships.
“Combinatorial auctions” may be the next big thing.
These allow businesses to bid for many things at
the same time, taking into account the fact that the
different goods may be complementary (it is worth
more to have both than just one) or substitutes (if
you get one, you do not want the other). Charles
Plott, an economist whose company,
Computerised Market Systems, is developing a
range of complex auctions, is currently testing an
auction for radio licences: the more you have of
these the better. It tells the bidder in seconds if his
bid would succeed, and, if not, what to do to win.
Also growing fast are highly specialised business
exchanges, such as e-STEEL, a steel exchange.
These are, in effect, two-way auctions bringing
together many buyers and sellers. This resembles a
financial exchange where buyers and sellers submit
the prices they are willing to pay (the bid) or sell at
(the asking price); when matches are found, a trade
takes place.
A year ago, there were around ten online business
exchanges, offering products such as computer
chips and road-freight capacity. Now there are
300-500; and the total is forecast to rise quickly to
several thousand. Most of them began as bulletin
boards that posted fixed prices, but they are
rapidly switching to dynamic pricing by auction.
The combination of Internet and auctions also
makes possible the creation of entirely new
“info-markets”. Hewlett-Packard, for instance, is
testing (with Mr Plott) a two-way auction-market
for securities whose value depends on how many
computers (and some other products) the company
sells during a particular period. Only HP personnel
who are likely to have relevant inside information
can participate. Only the security that represents
the actual sales outturn pays a substantial dividend;
the rest pay nothing. People can trade as often as
they like. Price is set by supply and demand.
The attraction to HP—and potentially many more
companies—is that continuous auction-markets of
this sort offer a much better way of gleaning
valuable information. That is because traders have
a strong incentive get their prediction right (rather
than say what they think their managers want to
hear). So far, in each of 19 test runs, HP has found
that the system is better at predicting actual sales
than in-house forecasts.
Beware the winner's curse
There are dangers in the spread of auctions.
According to Gerald Faulhaber of the Wharton
School, people who use Internet auctions are likely
to be different from those who do not.
Online-auction fans are probably quite
price-sensitive and so get a good deal; the others,
maybe less well-informed, are more at risk of being
exploited.
Online auctions, like offline ones, will always be at
risk of collusion and fraud. And there is the
“winner's curse”—the tendency for a bidder to be
successful only because he has paid too much.
However, this occurs more often when the auction
is by single, sealed bids; straightforward
ascending-price auctions, which are fairly easy to
offer on the Internet, carry less risk of this because
participants can see the rate at which other bidders
are dropping out.
Although prices are likely to become more
efficient, that does not mean they will all get lower.
According to Bill Sahlman of Harvard Business
School, the price of second-hand items is likely to
rise. This is because online auctions will create a
much deeper market. But prices of new things are
likely to fall, not least because of greater
competition from the second-hand market.
Some sellers are likely to try hard to slow the
progress of auctions that increase price
competition, as they do not want their margins
squeezed. But once competitors start to use
dynamic-auction pricing, they may be forced to
follow suit. And the trend is clear: towards happier
customers and more competitively priced markets.
Thanks to Internet auctions, some big inefficiencies
in the price mechanism will soon be going, going,
gone.
LINKS
A list of online auctioneers is available at
Yahoo!. The Economics Department of Johns
Hopkins University has pages dedicated to the
French economist Leon Walras. W.R.
Hambrecht's Open IPO system is up and
running. An indispensable site for auction
fanatics is Weird e-bay finds. An outsourced
auction host is FairMarket.
Business-to-business auctions take place at
Freemarkets. More complex bidding strategies
will soon be possible courtesy of
TradingDynamics. Some of Charles Plott's
experimental auctions are available at the
California Institute of Technology's Laboratory
for Experimental Economics and Political
Science. For articles about economic theories
of auctions, try Market Design.
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