April 15, 2006

1
Auction Principles
I. Economic and Behavioral Foundations of
Pricing
II. Innovative Pricing Concepts and Tools
III. Internet Pricing Models
2
Outline

• Lessons from Auction Simulation Exercise
• Optimal bidding and reserve price
• Two important auction principles
• Economics of Ebays Business Model
• Revenue model design

3
Independent Private-value English Auction

• Buyers valuations (WTPs) are independent of each
  other (e.g., antique art, collectibles, Jewelry
  Gemstones, etc.) (for own consumption)
• In our simulation exercise, buyers WTPs for the
  airline ticket are independent draws from a
  uniform distribution (0, 1000)
• An open English ascending bid auction
• What is the optimal bidding strategy?
• What is the optimal reserve price?

4
Optimal Bidding Strategy (one seller)

• If there is no snipping (auction is closed only
  when no bids are submitted for a certain
  duration), the auction theory predicts that
  buyers should slowly increase their bids until
  the highest bid exceeds their WTPs
• The open English auction mechanism induces truth
  revealing of WTPs (price points where bidders
  drop from the auction)
• Revenue Second highest WTP

5
Predicted Versus Actual Bids and Reserve Price
6
Prices at Each Round
3rd highest WTP
Price of 2nd item
Price of 1st item
Round 1
839.0
350.0
732.0
Round 2
850.0
850.0
610.0
Round 3
662.0
642.0
671.0
Round 4
798.0
760.0
790.0
Round 5
630.0
613.0
580.0
Round 6
674.0
650.0
631.0
7
Predicted Versus Actual Bids and Reserve Price
8
Expected Seller Revenue (one seller)

• Let buyer WTPs (independently drawn from an
  uniform distribution) are denoted by WTP1, WTP2,
  , WTPn-1, WTPn
• Arrange them in an ascending order and denote
  ranked bids by WTP(1), WTP(2), , WTP(n-1),
  WTP(n). That is, we have WTP(1) WTP(n-1)
• Expected Revenue

9
Expected Revenue versus Number of Bidders
10
Optimal Reserve Price (one seller) (uniform
distribution)

• Optimal reserve price
• If the reserve price is smaller than the second
  highest WTP, reserve price has no revenue effect
  on the bidding process
• If it is between the highest and the second
  highest WTPs, it will force the highest bidder to
  go beyond the second highest WTP (the point where
  the second highest bidder drops out).

11
Predicted Versus Actual Bids and Reserve Price
12
Revelation Principle

• Revelation Principle All buyers (except the
  winner) end up revealing their WTPs for the item
  to the sellers. Put differently, sellers can
  discover distribution of buyers WTPs via the
  auction mechanism. This is not the case for other
  pricing mechanisms (e.g., seller posted price and
  priceline model)
• Application Use open English auction to discover
  the distribution of WTPs and then use seller
  posted price model to maximize share of surplus

13
Efficiency Principle

• Efficiency Principle The auction mechanism
  guarantees that the item always goes to the buyer
  with the highest WTP in a market. Again, this is
  not always the case for other pricing mechanisms
• (inefficiency 0 (predicted) versus 1.6
  (actual))
• Observation Auction model is likely to dominate
  the other price models in terms of total social
  surplus generated.

14
Maximum Possible Surplus (MPS)
WTP
Buyer 1 40 Buyer 2 20 Buyer 3 15 Buyer
4 90 Buyer 5 60Buyer 6 50
Seller 1 c0
Seller 2 c0
MPS 40 90 60 50 240
15
The Winning Team

• The winning team is Group 4
• The prize is

16
Disadvantages of Auctions

• Can be stressful for some buyers, especially for
  end consumers (this can be however solved by
  proxy bidding). Thus, it is less likely to work
  for low purchase-involvement product categories
• There are more losers than winners (and losers
  are less likely to revisit the website)
• Strategic manipulation (e.g., shilling)

17
Next Class Design of Auction Format

• Dutch auction (D) (e.g, www.landsend.com )
• First-price sealed-bid auction (F) (e.g., US
  Treasury bills, supply contracts government
  procurement (10 GDP))
• Second-price sealed-bid (Vickrey) auction (S)
  (e.g., www.sandafayre.com NZs communication
  spectrum rights)
• English auction (E) (e.g., www.ebay.com
  www.yahoo.com )

18
Ebays business model
Price Setting Party
Buyer
Seller Buyer
Seller

Static
Price Over Time
ebay.com
Dynamic
http//www.ebay.com/
19
Ebays Current Status in 2004

• Listings - New listings totaled a record 348.0
  million in Q3-04, 48 higher than the 234.6
  million listings reported in Q3-03.
• Confirmed Registered Users - Cumulative confirmed
  registered users at the end of Q3-04 totaled a
  record 125.0 million, representing a 46 increase
  over the 85.5 million users reported at the end
  of Q3-03.
• Active Users - Active users, the number of users
  on the eBay platform who bid, bought, listed or
  sold an item over the trailing 12 months,
  increased to 51.7 million, a 38 increase over
  the 37.4 million active users reported in the
  same period a year ago.

20
Ebays Original Revenue Model
Revenue Levers

• M Total number of items listed per year
• Feei Insertion fee of item i
• Comi Final value fee of item i
• Ii 1 if item i is sold 0 otherwise
• M depends on number of people in the community
• Comi x Ii increases with price or seller surplus

21
Ebays Original Revenue Model
Biggest strength of the revenue model Revenues
increase linearly with M but costs do not
increase with M. (scalability
property)
22
Ways to Enhance Ebays Revenue

• Increase M
• Increase size of community,
• Enter new markets and product categories
• Increase turnover (e.g., reduce bidding duration,
  encourage setting of buyout prices)
• Increase Feei
• Encourage more pictures and promotion of items
• Increase Comi
• Increase average number of bidders / auction (so
  as to increase seller surplus)
• Encourage high-priced items (e.g., electronics,
  cars)
• Increase Ii
• Increase average number of bidders / auction so
  as to increase the probability that the highest
  bid reserve price
• Encourage a lower reserve price (e.g., the recent
  increase in insertion fee for reserve price
  auction)

23
EBays Revised Revenue Model

• Fees to list an item
• for regular auctions, fees is a function of
  starting price
• for vehicles, a function of type of vehicles
• for real estate, a function of types of
  properties and listing type
• Picture Service Feesfirst picture free,
  additional picture or bigger picture incurs fees
• Listing upgrade fees various options to promote
  items
• Final value fees
• for regular auction, charged when reserve met, at
  a function of the closing bid
• For vehicles, charged when the first bid over the
  reserve price is placed (regardless of whether
  sale is finally made)
• For real estate, a fixed fee for land/time share
  where there is successful high bid on the item
  and no fees for other type of real estates
• Reservation Price Feescharged only if item not
  sold, a function of reserve price

24
Ways to Enhance Customer Experience

• Bidder Management
• Smart search capability to narrow consideration
  set
• Winner Management
• Trust and safety initiatives
• Loser Management For every winner, there are
  (n-1) losers. Find ways to get them to bid again
• Follow-up emails on availability of related items
• Seller Management
• Loyalty programs for frequent sellers

25
Recipe for Continued Market Leadership

• Liquidity, liquidity, liquidity
• Keep Existing Customers Happy
• Increase switching costs
• Increase post-auction satisfaction
• Acquire New Customers
• New markets (e.g., Canada, UK, China, etc.)
• New products (especially high-priced items)
• Direct acquisition of customers / sites

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Punchline

• Open English Auction
• Revelation Principle
• Efficiency Principle
• Ebays Business Model
• Revenue increases with seller surplus
• Liquidity promotes lock-in Keep existing
  customers happy and acquire new customers
• Diversification New markets and new products
  (especially high-priced items)

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Exercise on Revenue Model Design

• Visit google answers http//answers.google.com/an
  swers/
• Figure out its revenue model and levers?

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Google Answers Revenue Model

• M Total number of questions posted per year
• 0.50 A posting fee of 50 cents per question
• Ii 1 if question i is answered 0 otherwise
• Pi Buyers posted price for question i
• Si 1 if question i has sponsored links 0
  otherwise
• NCi Number of clicks for question i
• ADi Average fee per click

http//answers.google.com/answers/faq.htmlcost