Managerial Economics: Auctions Can Maximize Profits

Managerial economic study seeks to define the ways in which a business can price products in order to maximize profit. As it turns out, an auction can provide the perfect market for profit maximization for some products.

Auctions are situations where potential buyers compete for the right to own a good, or anything of value. As in any situation, the seller in an auction wants the highest possible price, while the buyer wants the lowest possible price. What makes an auction different is the competition among buyers, which can lead to a higher price for the seller.

There’s nothing like an eBay auction. First, you can find almost anything on eBay — from accordions to z-scale model trains. And there’s nothing like bidding. You hover over the computer as the seconds tick off, waiting to get in that last bid. But be careful — get too excited and you may pay more than the item is worth to you.

The English auction: Last bid wins

An English auction is the auction you’re probably most familiar with. In an English auction, the auction starts at a low price set by the seller. Potential buyers, or bidders, incrementally raise the price until no one is willing to bid the price higher. At that point, the item is sold to the last individual to bid.

In an English auction, you know what other bidders are willing to pay at any given point. Your decision on whether or not to bid is simply determined by whether or not you’re willing to pay a higher amount.

Five hundred acres of farmland are being auctioned. There are three individuals willing to bid on the land — Oliver Wendell Douglas, John Kent, and Owen Lars. Douglas is willing to pay $4,000 per acre, Kent is willing to pay $4,200 per acre, and Lars is willing to pay $5,000 per acre.

To determine who ultimately purchases the land in an English auction and how much the individual pays, you take the following steps:

  1. All three individuals will bid as long as the price is $4,000 or less.

    All three individuals are willing to pay less than $4,000 for the land.

  2. Only Kent and Lars bid at prices between $4,000 and $4,200.

    Douglas drops out of the auction because he’s not willing to pay more than $4,000.

  3. Lars purchases the land at the first bid over $4,200.

    After the price per acre exceeds $4,200, Kent drops out of the auction, leaving Lars as the only bidder. Thus, the minimum amount Lars must spend to purchase the land is $4,200.01.

The winner of the English auction generally has to bid just a little more than the individual who places the second highest value on the item.

The Dutch auction: First bid wins

In a Dutch auction, the first bid wins. The bidding starts with the seller asking an extremely high price — a price nobody is willing to pay. The price is then gradually lowered until one buyer indicates a willingness to purchase the item. At that point, the auction is over and the item sold.

In a Dutch auction, no information regarding other bidders’ preferences is available to potential buyers. Because the first bid is the winning bid, potential buyers can’t determine the item’s potential value to anyone else. As a result, to avoid losing the opportunity to purchase the item, buyers tend to bid the maximum amount they’re willing to pay.

As with the English auction in the last example, assume that 500 acres of farmland are being auctioned. Again, three individuals are willing to bid on the land — Oliver Wendell Douglas, John Kent, and Owen Lars. Douglas is willing to pay $4,000 per acre, Kent is willing to pay $4,200 per acre, and Lars is willing to pay $5,000 per acre.

To determine who ultimately purchases the land in a Dutch auction and how much the individual pays, you take the following steps:

  1. The auction starts at an extremely high price; perhaps $10,000 per acre.

    The auctioneer sets the price so high that nobody is willing to purchase the land.

  2. The auctioneer progressively lowers price.

    As long as the price remains higher than the price anyone is willing to pay, no one bids. However, potential buyers don’t know anything about other bidders’ preferences. Potential buyers start getting nervous about losing the opportunity to buy the land as the auction price is lowered toward the price they’re willing to pay.

  3. The price is lowered to $5,000 and Lars purchases the land by making the first and only bid.

    Because Lars knows nothing about the other bidders’ preferences, he bids as soon as the land hits the price he’s willing to pay, and the auction ends.

Dutch auction winners tend to bid the maximum amount they’re willing to pay.

In comparing the English auction to the Dutch auction, you should note that the winning bidder remains the same — Lars in the examples. However, in the English auction, Lars winning bid was only $4,200.01, while in the Dutch auction his winning bid was $5,000.

The sealed-bid auction

In a first-price, sealed-bid auction, potential buyers submit written bids without knowing what anyone else is bidding. The auctioneer collects the bids and sells the item to the highest bidder.

In both an English auction and a sealed-bid auction, the item is sold to the highest bidder. However, in a sealed-bid auction, potential buyers don’t know anything about the amount others are willing to bid. There is no bidding back-and-forth. As a result, bidders tend to bid the maximum amount they’re willing to pay with the result being similar to a Dutch auction.

Whenever risk is present, even the risk of not buying an item you want at an auction, you can’t be sure of the outcome. This risk can be very stressful. So, if you want to further reduce stress, you can always follow humorist Frank McKinney Hubbard’s advice, “The safe way to double your money is to fold it over once and put it in your pocket.”

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