Saturday, April 28, 2007

Some of the Economic Mechanics of Auctions

FOXNews has an article about economist Susan Athey - something of a two page bio / interview. To be honest, I found most of the article rather boring. The part I found interesting and thought worth passing on was the author's exposition of some work Athey did with regard to timberland auctions and the way that they are conducted:

"Research [Athey] began as an undergraduate student has altered the way the American, Canadian and Australian governments auction off timberland. For instance, it was known that sealed bid auctions generate more money, i.e. higher bids, than those that allow open bidding. However, no one understood the reason for this.

"Athey helped solve the mystery. First, she mathematically predicted what buyers
should be willing to pay in an open auction. When they consistently came in lower than expected, the only plausible explanation was that 'bidders were colluding.'

"In other words, logging firms were agreeing, 'You let me win this round, I’ll let you win the next one.'

"You might be thinking, 'Duh!
Of course they were!' But it’s one thing to suspect this is going on and quite another to objectively demonstrate it.

"On the other hand, auctions that require bidders to submit
sealed bids raise more revenue than expected. Although competing firms might have an informal agreement on who should win a particular auction, the fact that bids are secret means the parties involved can’t confirm that the other side is sticking to the bargain. This causes each firm to bid higher than it would in an open auction.

"In addition, Athey found there’s another factor at work: increased competition.
Small logging operations are more likely to participate in sealed bid timber auctions because they have an equal chance of winning as the big guys — who, with their deeper pockets, could simply out-bid them in a live, out-cry auction.

"Another way Athey discovered bidders were gaming the system centers on how much they bid for certain types of trees. Again, it comes down to figuring out how to exploit the rules. When it pertains to timber auctions, two are central: (1) your overall bid is evaluated based on how much you
offer to pay for each species of tree you cut down; however, (2) the amount you ultimately pay is based on the number of trees of each species that you actually harvest.

'Say the government estimates that there’s a 50-50 percent mix of spruce and hemlock,' she says. 'But you think it’s mostly hemlock.' In this case, you’d put in a very high bid per spruce tree because you believe you won’t find a lot of those and, thus, won’t actually end up paying the price you’re offering. Your offer for the hemlocks might be slightly on the low side. But your generous bid for the spruce wood makes your overall bid much more attractive than your competitor’s so you win the auction.

"Think this doesn’t happen? According to Athey, 'In some extreme cases you have a firm bid five times the amount some trees could be worth.'

"This type of strategic thinking doesn’t just apply to trees! It affects everything from the approach companies use when they bid on government contracts to negotiating with a neighborhood kid to rake the leaves in your yard (you think there’s more of them than she/he does or vice versa)."


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