Imagine you agreed to pay $10.00 for an item, but when you got to the register the actual price is far less; let’s say $5.00. How would you like that? These are the exact types of deals that are available every day in markets all over the world for those who understand auction theory.
Many auction participants fail to grasp how auction theory affects their bidding strategy and they are not served by the omission. This is especially true in auctions in newer markets with unsophisticated bidders such as digital marketing and cryptocurrencies.
Auction Theory in a Nutshell
Any time a group of people decide to convene a market to establish the price of an asset, they must agree upon a set of rules to govern the it. Usually the market operator selects an auction variant since auctions are well understood and fair to all participants since each participant is free to bid as they wish but, yet this is only true if the participants understand the dynamics of the auction they’re bidding in.
Ascending Bid Auction (English Auction)
The auctioneer starts the price low, then raises it until only one bidder remains. In the early stages the auction is chaotic with many bids, then the auction calms down and a winner is selected.
Used for selling goods such as rare collectibles, commodities, or used cars.
Descending Bid Auction (Dutch Auction)
Opposite of the ascending bid auction, the auctioneer starts the price high, then lowers it until a single buyer submits a bid. Note that the first bid ends the auction for this asset, pretty intense!
Used by the US Treasury Department (and other governments. to sell debt-backed securities.
First Price Sealed Bid Auction
The auctioneer solicits bids from participants, then whoever bids the most wins the auction. The winner pays their agreed upon price. So, if the winner bids $10.00, they pay $10.00.
Used for competitive bid government contracts.
Second Price Sealed Bid Auction
Like the first price sealed bid auction, the auctioneer solicits bids from participants, then whoever has the highest bid wins the auction but yet, the price the winner pays is the second-highest price offered in the auction. So, the winner can bid $10.00, but pay only $5.01 if the second-highest bid is $5.00.
Used for Google Adwords, Facebook PPC and other ranking auctions.
Once you get away from the basic auction types, there is a cornucopia of auction types with different parameters. English Ship-makers used a candle auction where the highest bid on the table when the candle expired won the right to buy the ship.
If you’re bidding in an auction, make sure you know what type it is. Your bidding decisions will be better for it. If you’re in a second-price sealed bid auction, you may be bidding too low and leaving an immense amount of traffic on the table, but if you’re bidding on a declining price auction you may be overpaying without ever knowing.
See http://www.nuff.ox.ac.uk/users/klemperer/VirtualBook/07_Chapter1.pdf for more in-depth analysis of auction theory.