Why Do Sellers (Usually) Prefer Auctions?

This post comes to us from Jeremy Bulow of the Graduate School of Business, Stanford University, and Paul Klemperer of Nuffield College, University of Oxford.

In our paper Why Do Sellers (Usually) Prefer Auctions?, which was recently accepted for publication in the American Economic Review, we focus on comparing the two dominant methods for selling public companies – a simple “plain vanilla” simultaneous auction and an equally simple model of a sequential sales mechanism – when the seller has realistically-limited power and information. (Similar alternative ways of selling are observed for many other assets.) In both processes we model, an unknown number of potential bidders make entry decisions sequentially, before learning their values. In an auction, no credible bidding is possible until all entry decisions have been taken. In a sequential mechanism, potential bidders arrive in turn. Each one observes the current price and bidding history and decides whether to pay the entry cost to learn its value. If it does, and if it succeeds in outbidding any current incumbent (who can respond by raising its own bid), it can also make any additional “jump bid” it wishes to attempt to deter further entry. In both processes, we assume the seller does not have the power or credibility to commit to a take-it-or-leave-it minimum (reservation) price above a buyer’s minimum possible value.

Our central result is that the straightforward, level-playing-field competition that an auction creates is usually more profitable for a seller than a sequential process, even though the sequential mechanism is always more efficient in expectation (as measured by the winner’s expected value less expected aggregate entry costs). Bidders, by contrast, usually prefer to subvert an auction by making pre-emptive “jump bids” when they can. The sequential process is more efficient because although it attracts fewer bidders in expectation, it attracts more bidders when those bidders are most valuable – the existence or absence of early bids informs subsequent entry decisions and attracts additional bidders when the early ones turn out to be weak. But buyers’ ability to make pre-emptive jump bids, which inefficiently deter too many potential rivals from entering, harms the seller.

We identify several factors that may cause the expected revenue between the auction and the sequential mechanism to differ. First, even in the most favorable circumstances, a sequential process could only be superior if the queue of potential bidders is sufficiently longer than the number that would compete in an auction. Second, in a sequential mechanism bidders who deter entry choose a price where the expected distribution of winning values is such that an additional entrant would expect to earn zero. These two factors would be nullified with an infinite stream of potential bidders, and when parameters are such that the expected profits of the marginal bidder who does not enter the auction is exactly zero. The third factor is therefore crucial: the value of the winning bidder is generally less dispersed in the sequential process, because that process is more likely to attract one high-value bidder but will never attract more than one. But entrants prefer more dispersion in the value they have to beat, because dispersion makes the entrant’s option to buy more valuable. Therefore, the expected value of the top bidder in the auction must be higher than in the sequential mechanism to deter entry.

Thus, contrary to our usual instinct that auctions are profitable because they are efficient, it is precisely the inefficiency of the auction – that entry into it is relatively ill-informed and therefore leads to a more random outcome – that makes it more profitable for the seller.

The full paper is available for download here.

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