Everybody knows that E-Bay was a great innovation. By reducing transactions costs, and enabling users to establish
reputations, it has enabled millions of people to buy and sell goods in small quantities and of lower value than would have been possible in traditional bricks and mortar stores.
But there is another important, and little understood, innovation in the E-Bay model: the second price auction. “Oh, the second price auction”, I hear you cry in unison, “WTF is that?”
In a normal auction, the winning bidder pays the highest price that was bid. She wants to minimize the price that she will pay, so she tries to outbid the others, but by the smallest amount possible. No sensible bidder will bid more than the item is worth to them – so the highest possible bid is the value to the buyer. But buyers will generally bid less than the item is worth to them, hoping to win the auction with a bid that is just slightly bigger than the next biggest bid. In an open outcry auction, the winning bidder stops bidding when the last competing buyer folds – she does not, if she is sensible, continue to push the price up once there are no other bidders. In a sealed-bid auction, each buyer guesses what price the others will bid, and makes an offer just marginally above the highest price they expect somebody else to make. The best strategy is never to bid what the item is worth to you – because you might end up paying too much – but a little above what you anticipate your nearest rival will bid.
A second price auction works differently. The winning buyer is still the person who offers the highest bid; but the price that she actually pays is the amount bid by the next-highest bidder, plus a penny. So the amount that that you pay is de-linked from the amount that you bid.What is your best strategy in this case? Obviously you still don’t want to bid more than the item is worth to you – as you may end up having to pay very close to that price, and you don’t want to pay more than the item is worth to you. But now there is no longer an incentive to bid less than the item worth to you either, because lowering the price you bid won’t lower the price you pay. If you offer a bid of less than the value of the item, you may end up losing the auction to someone else, even though you could have bought the item for less than it is worth to you. So the rational bid in a second-price auction is to offer what the item is worth to you, no more and no less. This means that bids in a second price auction will be generally higher than in a normal auction, because there is no longer an incentive to hold down your bids below the value you place on the item.
How does this relate to E-Bay? Well, it turns out that E-Bay is a second-price auction. I bought a second hand cell-phone today on E-Bay, to replace my partner’s phone that I lost somewhere in the mountains of Colorado. She wanted a particular model, now discontinued; and it had to be red. Such a phone was being auctioned on E-Bay today. I told E-Bay’s system what
I was willing to pay (which was £50). The phone had reached £30. The automatic bidding system then bid £31 on my behalf. Another buyer had set a valuation higher than this, so the system put in a bid from him; and then the system automatically bid for me. I watched
E-Bay conduct an automatic bidding war until the price reached more than he was willing to pay. At that point, my bid was £36. Presumably, he had set an upper limit of £35.
And so after a few iterations, I got the phone for £36. As it happened, the amount I had to pay was substantially less than the £50 that I had told E-Bay I was prepared to pay (a small investment for domestic harmony). I got it at the price that my nearest rival was willing to pay. My own valuation was higher than the market value because I needed to buy this particular model in this particular colour. Because I know that this is how the E-Bay system works, I had entered my actual valuation into the E-Bay system, and then let the automatic bidding do the rest.
The seller never found out that I would have been prepared to pay quite a bit more for her phone. She got paid the market value of
the phone. If this had been a first price auction, I would have bid about £30, expecting that this would be about what other buyers would have offered. As it happened, I obtained a consumer surplus of £15 (the difference between what the phone was worth to me, and what
I had to pay); and the seller probably got as much, and possibly more, than she would have received in a first-price auction.
Because they sound complicated and counter-intuitive, and because they are hard to administer, second price auctions have not been used much in practice. Some governments have used them to auction spectrum licenses. But for online auctions, they work
The basics of the E-Bay system was programmed by Pierre Omidyar over the Labor Day weekend in 1995. His insight went beyond
creating a system that reduced transactions costs to enable millions of small raders to buy and sell. It was to use
a very clever piece of economic theory – the second price auction – to enable the market to function efficiently in the interests of both buyers and sellers. Though most of the traders on E-Bay have never heard of a second-price auction, they learn quickly how the system works, and adapt their behaviour accordingly.