E-COMMERCE AND AUCTIONS

• Advances in information technology have given birth to e-commerce and dynamic

pricing
 E-COMMERCE AND AUCTIONS

• Dynamic pricing is the practice of charging different prices by the minute or by the
customer
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• Two types of dynamic pricing: posted prices and price discovery

 E-COMMERCE AND AUCTIONS

• Posted Prices
• Prior to advances in IT, brick-and-mortar stores typically set fixed prices that would drop
once the product was in low demand or out of season
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• Posted Prices
• Today, IT allows firms to track inventory rapidly. When demand is high, prices rise.
When a product line is moving slowly, prices fall. Price changes can occur more much
rapidly.
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• E-commerce allows for personalized prices. Cookies allow them to track individual
browsing history and past purchases
• This allows them to post a price that is tailored to the person browsing the internet
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• With e-commerce, marginal cost includes click-through fees, which typically range from
$.40 to $1.50 per click
• The conversion rate is the probability that a click will lead to a sale
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• Example: A product can be purchased from a wholesaler for $25

• A price comparison website with a conversion rate of 4% charges $.50 per click
• This implies that, on average, 25 clicks are necessary to generate a sale (1/.04)
• The marginal cost of the product is $25 + ($.50 x 25) = $37.50
• The optimal price would depend on both marginal cost and the price elasticity of demand
• IT allows firms to experiment with various prices and determine a reasonably accurate
measure of price elasticity
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• Although the internet allows consumers to comparison shop, it also allows firms to track the prices of rival
firms
• If a firm’s price is too stable, competitors can undercut the price by a small amount and wind up as a lower-
priced firm on a price comparison site
• A firm can counter this by varying its price often.
• Firms should also be aware that online shoppers are more concerned with products than firms.
• Brick-and-mortar customers may visit WalMart and Target to find a television, but an online shopper will
search “televisions”
• Firms must, therefore, be aware that online rivals may not be the traditional brick-and-mortar rivals
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• 2. Price discovery
• Price discovery occurs when the consumer takes an active part in determining the price
• Ebay customers participate in an auction for goods
• Online advertisers often bid on keywords to get their ads seen
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• Types of auctions
• 1. English auction
• The traditional auction which a good is sold to the highest bidder
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English auction
• The highest bid to date can be viewed by all bidders
• Each bidder can re-bid
• Some online auctions allow bidders to submit their maximum price (aka reservation
price), which automatically raises the bid if the individual is outbid
• Once the bid exceeds the bidder’s reservation price, the bidder automatically withdraws
from the auction
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• Types of auctions
• 2. Dutch auction
• The good is initially offered at a high price
• The price is gradually lowered until the good is claimed
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• Google used the Dutch auction in its initial public offering

• The search engine offered 20 million shares at a price between $108 and $135/share and
gradually lowered it until the price reached $85/share
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• Types of auctions
• 3. First-price, sealed bid auction
• Each bidder submits a single bid without knowing what others have bid
• The party that submitted the highest bid pays a price equal to the bid
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• Types of auctions
• 3. Second-price, sealed bid auction (aka. Vickrey auction)
• Each bidder submits a single bid without knowing what others have bid
• The party that submitted the highest bid pays a price equal to the second highest bid
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• Google AdWords uses a form of the second-price, sealed bid auction

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• Google tabulates quality scores that determine:

• 1. The relationship between the ad and the keyword(s),
• 2. The quality of the results page to which the ad is linked
• 3. The percentage of times users click on the ad
Advertising ranks are tabulated by multiplying the advertiser’s maximum bid by its quality score
The advertiser with the highest advertisement rank pays the amount bid by the second highest
bidder
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• Example:
• 1. Advertiser A submits a maximum cost per click (CPC) of $2
• 2. Advertiser B submits a maximum CPC of $2.50
• 3. Advertiser A has a quality score of 10, and Advertiser B has a quality score of 7
• 4. The advertising rank for A is $2 x 10, or 20
• 5. The advertising rank for B is $2.50 x 7, or 15
• 6. The price that A must pay is equal to B’s advertising rank (15) divided by A’s quality score (10),
or 15/10 = $1.50
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• The Economics of Auctions

• 1. Private value auction
• A bidder is bidding for a good that the individual personally values (i.e. auctioning off a
painting)
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• Behavior in a private value auction

• Suppose we are auctioning off an autographed picture of LeBron James
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• Two sports fans, Josh and Sam, would like to buy an autographed picture of LeBron
James
• Each person formulates a reservation price (the maximum he would be willing to pay)

Josh Sam
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• Josh is willing to pay up to $200 and Sam is willing to pay up to $225

Josh: Sam:
$200 $225
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• English auction
• Each person bids publicly and is permitted to re-bid

Josh: Sam:
$200 $225
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• As soon as the bid reaches $200.01, Josh will drop out of the bidding
• Sam will win the auction and pay $200.01

Josh: Sam:
$200 $225
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• If we drop the penny, we conclude that in an English auction, the party with the highest
reservation price will win the auction and will pay a price equal to the reservation price of
the second highest bidder

Josh: Sam:
$200 $225
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• Second-price, sealed bid auction

• Each person bids one sealed bid.

Josh: Sam:
$200 $225
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• Second-price, sealed bid auction

• The high bidder wins the auction and pays a price equal to the second highest bid

Josh: Sam:
$200 $225
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• Recall that each party only knows his own reservation price.
• What should Sam bid?

Josh: Sam:
$200 $225
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• If both parties bid their reservation prices, Sam will win the auction and pay $200

Josh: Sam:
$200 $225
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• If Sam bids less than $225, he risks being outbid by Josh

Josh: Sam:
$215 $210
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• If Sam bids more than $225, he will pay more than $225 if Josh bids more than $225

Josh: Sam:
$230 $235
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• Sam’s incentive is to bid his reservation price.

• If he does, he maximizes his chances of winning without overpaying

Josh: Sam:
$200 $225
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• This implies that Josh’s incentive is also to bid his reservation price

Josh: Sam:
$200 $225
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• In a second-price, sealed bid auction, the party with the highest reservation price will win
the auction and pay a price equal to the second highest reservation price

Josh: Sam:
$200 $225
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• Dutch auction
• The auction begins with a high price, which is gradually lowered until the bid is claimed

Josh: Sam:
$200 $225
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• Dutch auction
• Clearly, Sam will not claim the bid until it drops to his reservation price

Josh: Sam:
$200 $225
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• But should he claim it? If he does, he gets the picture and pays $225, but does not earn
any consumer surplus

Josh: Sam:
$200 $225
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• By allowing the bid to continue to drop, Sam could still win the auction and pay a lower
price

Josh: Sam:
$200 $225
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• If Sam had perfect information, he would allow the bid to drop to $200.01

Josh: Sam:
$200 $225
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• Because he doesn’t know Josh’s reservation price, he risks losing the auction by allowing
the bid to drop

Josh: Sam:
$200 $225
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• Therefore, Sam must weigh the benefits of allowing the bid to drop (winning the auction
at a lower price) against the costs (not winning the auction)

Josh: Sam:
$200 $225
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• First-price, sealed bid auction

• Each bidder submits one sealed bid. The high bidder pays a price equal to his bid

Josh: Sam:
$200 $225
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• The strategy is the same as in the Dutch auction. If Sam submits his reservation price, he
maximizes his chances of winning the auction, but if he wins, he earns no consumer
surplus

Josh: Sam:
$200 $225
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• He can still win by submitting a bid that is lower than his reservation price, but risks
being outbid by Josh

Josh: Sam:
$200 $225
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• Implications:
• 1. The price paid by the winner in the English auction is the same as the price paid by the
winner in the second-price, sealed bid auction
• 2. The price paid by the winner in the Dutch auction is the same as the price paid by the
winner in the first-price, sealed bid auction
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• Which price is higher: the English/second price auction or the Dutch/first price auction?
• That depends on the risk attitudes of the bidders
• In either the Dutch or first price auction, the bidder can maximize the odds of winning by
submitting/claiming the good at the individual’s reservation price
• Submitting a lower bid, or allowing the bid to continue to drop in order to win at a lower price carries a risk
of losing the auction
• A risk averse person is wary of losing the auction, and will submit a bid (or claim a bid) that is closer to their
reservation price than a risk neutral bidder
• A risk neutral person will allow the price to drop to what he perceives as the second highest reservation price
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• What can the firm do to increase the revenue from the auction?
• 1. Increase the number of bidders
• The greater the number of bidders, the smaller the gap between the winning bid and the
second highest bid
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• 2. Establish a minimum selling price

• If the minimum price is higher than all bids, the good is not sold and the auction begins again at a lower minimum
• If the two highest bids exceed the minimum price, the minimum has no effect on the actual selling price
• Example: Sam’s reservation price is $225, Josh’s reservation price is $200, and the minimum price is $150
• Sam will win the auction and pay $200
• If the two highest bids are on opposite sides of the minimum price, the winner pays the minimum price rather than
the second highest bid
• Example: Sam’s reservation price is $225, Josh’s reservation price is $200, and the minimum selling price is $210
• Sam will win the auction and pay $210
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• The Economics of Auctions

• 2. Common value auction
• The good being auctioned has the same value to all bidders (i.e. auctioning off the rights
to an oil field)
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• The critical characteristic is that, whereas the good being auctioned has the same value to
all bidders, its value is not known with certainty
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• Imagine auctioning off a jar of coins

• The high bidder gets the jar, but no one knows how much money is in the jar
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• Each bidder must estimate how much money is in the jar before bidding
• The high bidder is likely to have the most generous estimate of what’s in the jar
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• This creates the possibility that the high bidder will win the auction, but bid more than
what is in the jar
• Economists call this the winner’s curse
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• The winner’s curse is less likely to occur in the English auction

• The bidder estimates the value of the good (i.e. the amount of money in the jar), but infers information
from the other bidders about their estimates
• Example: The bidder believes that $20 is in the jar, but 80% of the bidders have dropped out of the
auction by the time the bid reaches $15.
• Example: The bidder believes that $20 is in the jar, but everyone is still in the auction when the bid
reaches $18
• Inferring this information causes bidders to be more aggressive, resulting in higher bids that might be
seen in a first-price, sealed bid or Dutch auction
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• The winner’s curse is also less likely to occur in the second-price, sealed bid auction
• The bidder knows that if he wins the auction, he must pay the second highest bid
• Therefore, the bidder can bid his reservation price as his bid with less concern about
overpaying
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• The risk of the winner’s curse is highest with the Dutch or first-price, sealed bid auction
• If the bidder claims the good at a given bid in a Dutch auction, he likely has the most
generous estimate of the true value of the good
• The winner of a first-priced, sealed bid auction probably has the most generous estimate
of the true value of the good
• This causes bidders to be more cautious in their bidding behavior (it’s better not to win
the auction than to win the auction and overpay)
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• The best bidder strategy in a common value auction with a first-price or Dutch auction
• 1. Assume that if you bid your reservation price, you will win the auction and overpay
• 2. Adjust your bid downward to what you believe might be the second-highest bid
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• Ranking the bids in a common value auction:

• English > Second-price > Dutch = First-price