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Reflect on the assigned readings for the week. Identify what you thought was the most important concept(s), method(s), term(s), and/or any other thing that you felt was worthy of your understanding.
Also, provide a graduate-level response to each of the following questions:

American Airlines and British Airways are proposing to merge. If British pilots and American pilots are represented by different unions, how would this merger affect airline costs?

[Your initial post should be based upon the assigned reading for the week( ATTACHED BELOW ) , so the textbook should be a source listed in your reference section and cited within the body of the text. Other sources are not required but feel free to use them if they aid in your discussion]. [Your initial post should be at least 450+ words and in APA format (including Times New Roman with font size 12 and double spaced). Post the actual body of your paper in the discussion thread then attach a Word version of the paper for APA review].

Bargaining

PowerPoint Slides

Vanderbilt

CHAPTER

Strategic view of bargaining: model as either a simultaneous-move or sequential-move game.

A player can gain bigger share of the \“pie” by

changing a simultaneous-move game into a sequential- move game with a ﬁrst-mover advantage;

or by

committing to a position.

Credible commitments (threats) are difficult to make because they require players to commit to a course of action against their self-interest. Thus, the best threat is one you never have to use.

©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images

The strategic view of bargaining focuses on how the outcome of bargaining games depends on who moves ﬁrst and who can commit to a bargaining position, as well as whether the other player can make a counteroffer.

The non-strategic view of bargaining focuses on the gains and alternatives to agreement to determine the outcome of barganing.

Main insight: The gains from agreement relative to the alternatives to agreement determine the terms of any agreement.

Anything you can do to increase your opponent’s relative gains from reaching agreement or to decrease your own will improve your bargaining position.

continued

1: NBA

In summer 2011, National Basketball Assc. owners were negotiating with the players’ union over how to split revenues

Union wanted 57%, owners only offered 50%

Owners locked out the players, cancelling the start of the season

After months of legal threats and lost revenue, players finally accepted owners’ initial offer

2: Texaco
In 1985, Texaco was found guilty by a Texas jury for interfering with Pennzoil’s attempt to buy Getty Oil.
Texaco was fined $10.5 billion, but appealed the verdict and began negotiating with Pennzoil.
In 1987, Texaco filed for bankruptcy. Pennzoil was then unable to seize control of Texaco’s assets.
Texaco was also freed from the responsibility to pay interest and dividends.
One year later Texaco and Pennzoil settled the case, with Texaco having to pay only $3 billion. Texaco successfully used bankruptcy to reduce its liability by over 70%
This chapter examines bargaining, and strategies to improve your bargaining position, like those used by Bear Stearns and Texaco .
5

Introduction: Bargaining
There are two complementary ways to look at bargaining:
the strategic view analyzes bargaining using the tools of game theory (ch 15). Bargaining can be viewed as either a simultaneous-move game with two equilibria or a sequential-move game, where one player gains an advantage by committing to a position.
the non-strategic view acknowledges that real life negotiations don’t have fixed rules as formal games do. This view postulates that the alternatives to agreement determine the terms of agreement, regardless of the rules of the negotiating game.
If you can increase your opponent’s relative gain, or decrease your own, you can gain a bigger share of the pie.
By declaring (or threatening) bankruptcy, Bear Stearns and Texaco were able to improve their bargaining “position”, i.e., by changing the alternatives to agreement, they changed the terms of agreement.
6

Bargaining: a simultaneous-move game
Example: Wage negotiations
Management and labor are bargaining over a fixed sum of $200 million
Two possible strategies are available to each player: “bargain hard” or “accommodate.”
If both bargain hard, no deal is reached. Neither side gains.
If both accommodate, they split the gains from trade.
If one player bargains hard and the other accommodates, then the player who bargains hard takes 75% of the “pie”
7

Bargaining: a simultaneous game (cont.)
There are two equilibria for this game
Management prefers the lower-left equilibrium
Labor prefers the upper-right.
This bargaining game has the same structure as a game of “chicken”
Each party can gain by committing to a position, which turns it into a sequential game
8

Bargaining: a sequential-move game
In sequential-move bargaining the first “player” makes an offer that the second “player” can accept or refuse.
Again to analyze a sequential-move game look ahead and reason back.
The first-mover “looks ahead and reasons back” to determine the how her rival will react to each possible move. Then the first-mover can determine the consequences of each possible move.
In this case, the sequential-move games present a “first-mover advantage,” i.e., by moving first a player can gain an advantage.
Using the same wage negotiation example, we can look at sequential-move bargaining and first-mover advantage.
9

Bargaining game: first-mover advantage
Management “wins” by moving first and making a low offer
10

Bargaining game: first-mover advantage
Union can change the outcome by credibly committing to strike if a low offer is made
11

Sequential-move bargaining (cont.)
Because the management has the first-mover advantage, it is in their best interest to make a low offer, and it is in the union’s best interest to accept that offer.
However, if the union can effectively threaten to strike (in such a way that the management believes them) they can change the outcome of the game despite management’s first-mover advantage.
Credible threats are hard to make because they require the union act against its self interest.
If management doesn’t believe the threat, the union might actually have to follow through on the threat.
So, again, the best threat is one you never have to use.
12

Non-strategic View of Bargaining
The outcome in strategic bargaining “games” is dependent on the rules of the game, but in real life, the rules are not always clear.
John Nash proved that any reasonable outcome to a bargain would maximize the product of the bargainers’ surplus.
This is known as an “axiomatic” or “non-strategic” view of bargaining.
In this view, the gains from bargaining relative to the alternatives to bargaining, determine the terms of any bargain.
This view also teaches that to increase your bargaining power,
you can increase your opponent’s gain from reaching agreement or decrease your own.
If your rival has more to gain by agreeing, he becomes more eager to reach agreement, and accepts a smaller share of the surplus.
13

Non-strategic view (cont.)
Nash’s axiomatic approach:
[ S1(z) – D1 ] x [ (S2(z) – D2 ] , where:
z is the agreement
S1(z) is the value of the agreement to player 1 (sub 2 for player two)
D1 is “disagreement value,” or pay-off if no agreement is reached, for player 1 (sub 2 for player two)
So player 1’s gain from agreement is (S1(z) – D1)
14

Non-strategic view (cont.)
For example, two brothers are bargaining over a dollar.
If no agreement is reached, neither participant gains.
If they reach an agreement (z)
Player one, the older brother, has a surplus of z
Player two, the younger brother, has a surplus of 1 – z
Nash’s solution is for them to “split” the gains from trade, i.e., {½, ½} is the axiomatic solution.
But, now the older brother receives a $0.50 bonus for “sharing nicely,” and the total gain rises from $1.00 to $1.50
The Nash bargaining outcome is for the brothers to split to total gains – each receiving $0.75, meaning the older brother effectively shares half of his bonus.
By increasing the first player’s gain to reaching agreement, he becomes more eager to reach agreement, and “shares” his gain with his brother.
15

Bonuses for agreement
Giving a bonus for reaching agreement is similar to incentive compensation schemes used by many companies.
When salespeople are offered bonuses it increases their eagerness to reach agreement and this induces them to accept “weaker” agreements.
So giving salespeople such a bonus driven incentive will lead to lower prices when they negotiate with customers.
(This concept will be further addressed in chapter 20)
16

Alternatives to agreement
Nash’s bargaining solution incorporates the effect of alternatives to agreement on the agreement itself. This creates some sound bargaining advice:
To improve your own bargaining position, increase your opponent’s gain from reaching agreement, S2(z) – D2, or reduce your own gain from reaching agreement, S1(z) – D1.
When you increase your opponent’s gain in agreement, you make him more willing to agree.
Reducing your own gain makes you less willing to compromise and helps to improve your position.
17

How Nash’s view differs from strategic
The strategic view of bargaining places a greater emphasis on timing and commitment in determining the outcome of the game.
With the labor/management example, the union’s commitment to strike, or management making the first move, changes the equilibrium of the game.
But neither action changes the gains of the agreement so neither would affect the Nash bargaining outcome.
The Nash bargaining outcome incorporates the idea that if you decrease your own gain to agreement you become a better bargainer.
EXAMPLE: the best time to ask for a raise is when you have another attractive offer waiting for you, you have less to gain by reaching agreement. Your bargaining position improves.
This is similar to the idea of “opportunity cost.” The opportunity cost of staying at your current job is giving up the new offer; if the new job pays more, you’re costs (bottom line) go up.
18

Improving a Bargaining Position
Discussion Question: When is the best time to buy a car?
Hint: Remember, car salesmen are generally paid a commission for the sales they make.
Discussion Question: How can mergers or acquisitions improve bargaining power?
19

Merger bargaining example
A Managed Care Organization (MCO) markets its network to an employer
Network value is $100 if it contains either one of two local hospitals
But the value rises to $120 if it contains both
And there is no value without at least one of the hospitals
The gain to the MCO from adding either of the hospitals to its network when it already has the other is $20
Nash bargaining solution predicts this is evenly split
So, each hospital gets $10 for joining the MCO
But if the hospitals merge and bargain together,
The MCO can no longer drop one of the hospitals, so the gain from striking a bargain with the merged hospital is the full $120
The gain is evenly split in the Nash bargaining solution
The merged hospitals thus receive $60, a post-merger gain of $40
20

Health care mergers
In Rhode Island in 2003, Blue Cross Blue Shield (BCBS, the health insurance company covering state employees) hired PharmaCare to provide pharmaceutical services.
PharmaCare created a network of retail pharmacies willing to sell drugs to state employees at discounted rates.
The previous contract had allowed employees to buy from any pharmacy but was considerably more expensive.
In the new PharmaCare contract, 4 retail pharmacies were excluded from the plan. These 4 firms lobbied RI legislature to include them in the new plan and offered to provide the same discounted price but PharmCare declined their request to join.
Pharmacare maintained that allowing the other stores to join would eliminate the savings generated by having a restricted network. PharmaCare’s bargaining position would deteriorate.
Many politicians, though, like “freedom-of-choice” bills that would open any pharmacy willing to meet the negotiated prices.
21

Title?
Under the 2002 CHAOS (Create Havoc Around Our System) plan, flight attendants threatened to either stage a mass walkout for several days or to strike individual flights of Midwest Express, with no advance warning to either customers or management.
Midwest Express reacted by cancelling all flight attendant vacation, and threatened to lock out any employee who participated in the strike
Flight attendant union promised funding from its strike fund to support any attendant who ended up locked out.
The biggest strength of the union’s threat was that it could be effective without full implementation.
The threat of random strikes was enough to push passengers to other airlines.
After 30 days of CHAOS, the union successfully negotiated a new contract.
22

Management
Union
low offer generous offer
acceptstrike
0 , 0 150 , 50 50 , 150
acceptstrike
0 , 0

Management
Union
low offer generous offer
strike
0 , 0 50 , 150
acceptstrike
0 , 0

Making Decisions
with Uncertainty

Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images

CHAPTER

When you’re uncertain about the costs or beneﬁts of a decision, replace numbers with random variables and compute expected costs and benefits.

Uncertainty in pricing: When customers have unknown values, you face a familiar trade-off: Price high and sell only to high-value customers, or price low and sell to all customers.

If you can identify high-value and low-value customers, you can price discriminate and avoid the trade-off. To avoid being discriminated against, high-value customers will try to mimic the behavior and appearance of low-value customers.

Difference-in-difference estimators are a good way to gather information about the beneﬁts and costs of a decision. The ﬁrst difference is before versus after the decision or event. The second difference is the difference between a control and an experimental group.

If you are facing a decision in which one of your alternatives would work well in one state of the world, and you are uncertain about which state of the world you are in, think about how to minimize expected error costs.

continued

TeleSwitch

A large telecom supplier, TeleSwitch, sold its product only through distributors.

In 2000, their largest clients wanted to deal directly with TeleSwitch – and avoid the middle man distributor. TeleSwitch was unsure what to do.

They might lose large customers if they didn’t switch.

But, they might lose distributors (and their small customers) if they did.

There is a lower probability of losing dealers (because they would have to incur costs to change suppliers)

But this would have a much larger impact on profit.

How should we analyze decisions like this??

Introduction: Undertainty

This problem illustrates the type of uncertainty that exist in most business decisions.

This chapter looks at ways to help deal with uncertainty and arrive at decisions that will best profit your firm.

By modeling uncertainty, you can:

Learn to make better decisions

Identify the source(s) of risk in a decisions

Compute the value of collecting more information.

Modeling Uncertainty

To model uncertainty we use random variables to compute the expected costs and benefits of a decision.

Definition: a random variable is simply a way of representing numerical outcomes that occur with different probabilities.

To represent values that are uncertain,

list the possible values the variable could take,

assign a probability to each value, and

compute the expected values (average outcomes) by calculating a weighted average using the probabilities as the weights.

Random variables

Definition: a binomial random variable, X, can have two values, x1 or x2, with probabilities, p and 1-p. The expected value (mean) for a binomial random variable is:

E[X]=p*x1+(1-p)x2

Definition: a trinomial random variable, X, can have three values, x1, x2, or x3, with probabilities p1, p2, and 1-p1–p2. The mean for a trinomial random variable is:

E[X]= p1*x1+ p2*x2+(1- p1-p2) x3

How to model uncertainty

“Wheel of Cash” example:

The carnival game wheel is divided like a pie into thirds, with values of $100, $75, and $5 painted on each of the slices

The cost to play is $50.00

Should you play the game?

Three possible outcomes: $100, $75, and $5 with equal probability of occurring (assuming the wheel is “fair”)

Expected value of playing the game is

1/3 ($100) + 1/3 ($75) + 1/3 ($5) = $60

But, if the wheel is biased toward the $5 outcome, the
expected value is

1/6 ($100) + 1/6 ($75) + 2/3 ($5) = $32.50

TeleSwitch’s Decision Tree

The probability of losing customers is 0.6

The probability of losing distributors is 0.2

Entry Decision with Uncertainty
The probability of retaliation (no accommodation) to an entry decision (as modeled in ch 15) is 0.5
10

Dealing with uncertainty
Discussion: How do you respond to an invitation from a friend to invest in a real estate venture that depends on uncertain future demand and interest rates?
Calculate the potential gains and loses based on different combinations of high and low interest rates and high and low demand
Whoever proposed the venture probably presented the best case scenario (low interest rates and high demand) – and that is the only combination (of four possible outcomes) under which you will do well.
Either don’t invest or find a way that aligns your friend’s incentives with your own, i.e., he gets a payoff only if the venture does well.
11

Uncertainty in Pricing
Uncertainty in pricing arises when the demand for a product is unknown.
To model this uncertainty, classify the number and type of potential customers. For example:
High-value consumers willing to pay $8
Low-value consumers willing to pay $5
Suppose there are equal numbers of each consumer group
Discussion: If MC= $3, what is optimal price?
By pricing high, you would earn $5 per sale each time a high-value costumer shops – or %50 of the time
By pricing low, you would earn $2 per sale but would be able to sell to both high- and low-value costumers – 100% of the time.
12

Uncertainty in Pricing (cont’d.)
Answer: Price High
13

Price Discrimination Opportunity
If you can identify the two types of customers, set different prices to each group, and prevent arbitrage between them, then you can price discriminate.
Price of $8 to the high-value customers
Price of $5 to the low-value customers.
Discussion: When buying a new car, sales people discriminate between high- and low-value customers. How do they do this?
Discussion: What can you do to defeat this?
14

Natural experiments
To gather information about the benefits and costs of a decision you can run natural experiments.
Natural experiment example: A national restaurant chain
A regional manager wanted to test the profitability of a special holiday menu
To do this, the menu was introduced in half the restaurants in her region.
In comparing sales between the new menu locations and the regular menu locations (the control group) the manager hoped to isolate the effect of the holiday menu on profit.
15

Natural experiments (cont’d.)
This is a difference-in-difference estimator. The first difference is before vs. after the introduction of the menu; the second difference is the experimental vs. control groups
Difference-in-difference controls for unobserved factors that can influence changes
The manager found that sales jumped during the holiday season – but the increase was seen both in the control and experimental groups—both increased by the same amount.
The manager concluded that the holiday menu’s popularity came at the expense of the regular menu. So the holiday menu only cannibalized the regular menu’s demand and didn’t attract new customers to the restaurant.
16

Natural experiments (cont’d.)
Natural experiments can be useful in many different contexts.
When the FTC looked back at a 1998 gasoline merger in Louisville, they used their own version of a difference-in-difference estimator.
Three control cities (Chicago, Houston, and Arlington) were used to control for demand and supply shocks that could affect price.
The first difference was before vs. after the merger; the second difference was Louisville prices vs. prices in control cities– this allowed the FTC to isolate the effects of the merger and determine its effect
17

1998 LouisGasoline Merger
18

Minimizing expected error costs
Sometimes, when faced with a decision, instead of focusing on maximizing expected profits (benefits minus costs) it can be useful to think about minimizing expected “error costs.”
This approach is helpful when one alternative would work well only under certain conditions, and you are uncertain about whether the conditions hold.
For example, “should we impose a carbon tax?”
If global warming is caused by human activity then a carbon tax will help reduce it.
But if global warming is not caused by human activity, then a carbon tax would only reduce economic activity and would not cool the Earth.
19

Error costs (cont’d.)
The two global warming alternatives can be modeled by:
20
Type I error is the failure to tax when global warming (GW) is caused by human activity.
The Type II error is the implementation of a carbon tax when global warming (GW) is not caused by human activity.
The optimal decision is the one with the smaller expected error costs, i.e. Tax if (1-p)*Cost(Type I) < p*Cost(Type II) This type of analysis is especially useful for balancing the risks associated with pricing errors (over- v. under-), e.g., for airlines, hotels, cruise ships; as well as production errors (over v. under) Carbon Tax No Tax GW is caused by human activity (p) 0 (p) x (error cost II) GW is not caused by human activity (1-p) (1-p) x (error cost I) 0 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images Risk versus uncertainty Risk is how we characterize uncertainty about values that are variable. Risk is modeled using random variables. Uncertainty is uncertainty about the about the distribution of the random variables. E.g., which probabilities should be assigned to the various values the random variables can take? This difference is critical in financial markets. Risk can be predicted, priced and traded – people are comfortable with risk. Dealing with uncertainty is much more difficult. Mistaking risk for uncertainty can be a costly mistake 21 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images IndyMac: Risk vs. Uncertainty Risk never went away, investors were just ignoring it Black Swans & fat tails I have nothing against economists: you should let them entertain each others with their theories and elegant mathematics, [But]…do not give any of them risk-management responsibilities. —Nassim Nicholas Taleb 22 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images Dealing with uncertainty Uncertainty is unavoidable. So to cope with uncertainty in decision making, gather more or better information. Best Buy has used dispersed sets of non-experts to predict future variables, such as a holiday sales rate. Google uses internal prediction markets to generate demand and usage forecasting. The US Marines advise: Because we can never eliminate uncertainty, we must learn to fight effectively despite it. We can do this by developing simple, flexible plans; planning for likely contingencies; developing standing operating procedures; and fostering initiative among subordinates. 23 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images Risk versus uncertainty Part of the housing crisis can be attributed to an error in translating uncertainty to risk through a mathematical formula created by David Li. The formula was designed to measure the correlation between returns of various assets that made up collateralized debt obligations (CDOs). But there was uncertainty about how one asset’s failure would related to that of another asset. There was also a lack of historical data about relationships among the underlying assets. Li’s solution was to use past credit default swap (CDS) prices as an indication of correlation returns (clever but imperfect). CDS data came from a time when housing prices were on the rise, and the correlation changed during a period of decreasing prices. Nearly everyone was using this formula, and… we’ve seen how it all turned out 24 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images Telecom Firm Sell directly to large customers (.20) × $30 + (.80) × $130 = $110 Sell only through dealers (.60) × $100 + (.40) × $130 = $112 Distributors leave (probability = .20) Firm profit = $30 Distributors stay (probability = .80) Firm profit = $130 Large customers leave (probability = .60) Firm profit = $100 Large customers stay (probability = .40) Firm profit = $130 Entrant Enter (.50) × $60 + (.50) × $-40 = $10 Stay Out (.50) × $0 + (.50) × $0 = $0 Incumbent prices high (probability = .50) Entrant profit = $60 Incumbent prices low (probability = .50) Entrant profit = $-40 Incumbent prices high (probability = .50) Entrant profit = $0 Incumbent prices low (probability = .50) Entrant profit = $0 Pricing Decision Price High (.50) × $5 + (.50) × $0 = $2.50 Price Low (.50) × $2 + (.50) × $2 = $2 Get high-value customer (probability = .50) Profit = $5 Get low-value customer (probability = .50) Profit = $0 Get high-value customer (probability = .50) Profit = $2 Get low-value customer (probability = .50) Profit = $2

Auctions

018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images

CHAPTER

In oral or English auctions, the highest bidder wins by outbidding the second- highest bidder. This means that the second-highest bidders’ value determines the price.

A Vickrey or second-price auction is a sealed-bid auction in which the high bidder wins but pays only the second-highest bid. These auctions are equivalent to oral auctions and are well suited for use on the Internet.

In a sealed-bid ﬁrst-price auction, the high bidder wins and pays his value. Bidders must balance the benefits of bidding higher (a higher probability of winning) against the costs of bidding higher (reduced margin if they do win). Optimal bids are less than bidders’ private values.

Bidders can increase their proﬁt by agreeing not to bid against one another. Such collusion or bid rigging is more likely to occur in open auctions and in small, frequent auctions. If collusion is suspected,

do not hold open auctions;

do not hold small and frequent auctions;

do not disclose information to bidders—do not announce who the winners are, who else may be bidding, or what the winning bids were.

In a common-value auction, bidders bid below their estimates to avoid the winner’s curse. Oral auctions return higher prices in common-value auctions because they release more information than sealed-bid auctions.

continued

Bell Telephone

In 188

, Bell Telephone Company of Canada established Northern Electric to manufacture its telephone equipment.

By 2000, the company (now Nortel) had a market share of over $200 Billion

Decade of bad investments, declared bankruptcy in 2011

Nortel approved for sale by bankruptcy court

The court was unsure of the value of some of the company’s assets, such as the

000 patents, and decided to sell these assets with an auction.

The bidding started at $900 million but was pushed up to $

.5 billion after successive rounds of bidding.

Introduction: Auctions

Auctions are simply another form of competition, like price competition or bargaining.

CarBargains is one company that uses auctions to help car buyers.

In these auctions, though, sellers not buyers are competing.

Local car dealers offer prices to a single consumer in a sealed-bid auction.

Auctions set a price and identify the high-value buyer or low-cost seller.

Auctions are often used in combination with bargaining, e.g., first an auction is used to identify the high-value buyers and then there is a negotiation over the final price.

Oral Auctions

Definition: In an oral or English auction, bidders submit increasing bids until only one bidder remains. The item is awarded to this last remaining bidder.

Example: Suppose there are five bidders with values equal to {$5, $4, $3, $2, $1}.

The $5 bidder will win the auction, and bids only slightly over $4 to do so.

The “price” or winning bid is $4, or slightly above.

The winning bidder is willing to pay $5 but doesn’t have to, so the losing bidders determine the price in oral auctions.

Auctions identify the high-value bidder (“efficiency”) and set a price for an item, with no negotiating necessary. For these reasons, economists love auctions.

Benefits of auctions

Example: auction vs. posted-price

A retail store is unsure whether they should price high ($8) or low ($5) for a certain item.

If the store prices high, they sell to only high-value buyers (half the time). If the store prices low, they sell to all customers at a lower price.

If MC = $3, then pricing high is preferable

(.5)($8-$3) = $2.50 [versus (1.0)($5-$3) = $2.00]

If the store uses an auction instead, and two bidders show up with values $8 and $5 – meaning there is again a .5 chance of selling to a high-value costumer – what will the revenue of the sale be?

Oral Auctions (cont’d)

Second-Price Auctions
Definition: A Vickrey or second-price auction is a sealed-bid auction in which the item is awarded to the highest bidder, but the winner pays only the second-highest bid.
This at first seems counterintuitive – why leave money on the table? But second-price auctions encourage bidders to bid more aggressively.
William Vickrey and James A. Mirrlees shared the 1996 Nobel Prize in Economics for their work inventing the Vickrey auction and establishing that there is no difference in outcome between an oral and second-price auction.
9

Second-price auctions (cont’d)
Because the winning bidder pays the price of the second-highest bid, bidders are willing to bid up to their values, so the outcome is the same as an oral auction.
Second-price auctions are easier to run than oral auctions because the bidders can bid in remotely, and asychronously (at different places and times).
Discussion: Why are eBay auctions equivalent to second-price auctions?
Discussion: Why does eBay use second-price auctions?
10

Sealed-Bid Auctions
Definition: In a sealed-bid first-price auction, the highest bidder gets the item at a price equal to the highest bid.
These auctions present a difficult trade-off for bidders:
A higher bid reduces the profit if you win, but
Also raises probability of winning
Bidders balance these two effects by bidding below their values (“shading”).
Experience and knowing the competing bidders are the keys to these auctions, but in general, bid more aggressively – shade less – if the competition is strong.
11

Bid Rigging or Collusion
Example: an oral auction with bidder values of {$5, $4, $3, $2, $1}.
Suppose that in this auction the two high-value bidders have formed a bidding ring (also known as a cartel).
The two decide NOT to bid against each other, so the cartel wins the item by outbidding the non-cartel members, i.e., price= $3. The cartel makes a profit of $1 which typically is split evenly between members.
Bid-rigging is a criminal violation of antitrust laws in the US and many other countries.
In one type of bid-rigging, cartel members re-auction the items won in a second-auction to cartel members in a second or “knockout” auction.
12

Bid-rigging / Collusion (cont’d)
Another type of collusion is known as a bid-rotation scheme. This scheme uses quid pro quo bidding behavior.
Bidders in these cartels submit weak bids or refrain from bidding against each other until it is their turn to “win.”
In a bid-rotation scheme each cartel member must wait for his turn to win – a weakness that leaves these schemes vulnerable to cheating.
Proposition: Collusion is more likely in oral auctions.
Proposition: Collusion is more likely in small, frequent auctions.
13

Bid-rigging: Frozen Fish Conspiracy
After this cartel was broken the price of fish dropped 23%
Investigators backcast from the competition period into the collusive period to determine the cartel’s effect, i.e., what the price would have been, “but for” the conspiracy.
14

Reacting to bid-rigging
The government is frequently the victim of bid-rigging schemes.
Learning from the government’s experience, some tips to avoid collusion:
Do not rely on purchasing agents (those running the auction) who have little interest in buying at a low price. Instead, reward agents for making good (high-quality and low-price) purchases.
Do not entangle purchasing agents with masses of red tape. Instead, permit them to negotiate (e.g., to bargain with the bidders) if they suspect bid rigging.
But beware of patronage
Do not use the procurement process to further a social agenda (small business set-asides, public lands, national defense, etc.) that is irrelevant to the goal of purchasing goods at low prices.
15

Avoiding collusion (cont’d)
Keep cartels in the dark, so it is difficult for them to organize and to punish cheaters.
do not hold open auctions;
do not hold small and frequent auctions;
do not disclose information to bidders—do not announce who the other bidders are, who the winners are, or what the winning bids are.
16

Common-Value Auctions
Definition: In a common-value auction, the value is the same for each bidder, but no one knows what it is. Each bidder has only an estimate of the value.
Be careful in these auctions lest you suffer the “winner’s curse”
If you win, you learn that you were the one who had the highest and most optimistic estimate of the unknown value of the item
Bidders should reduce their value estimates to protect against this.
If you are the auctioneer, release info to mitigate winners’ curse.
Winner’s curse is worse when
More bidders
Other bidders have better information
17

Common-Value Auctions (cont’d)
To avoid the winner’s curse bid less aggressively as the number of bidders increases.
In common-value settings, oral auctions return higher prices than sealed-bid auctions because oral bids reveal information.
But oral auctions are more vulnerable to collusion.
Discussion: Why do bidders wait until the last minute of the auction to submit bids on eBay?
18

Bidder 1 Bidder 2 Bidder 3 Probability Winning bid
$5 $5 $5 .125 $5
$5 $5 $8 .125 $5
$5 $8 $5 .125 $5
$8 $5 $5 .125 $5
$5 $8 $8 .125 $8
$8 $5 $8 .125 $8
$8 $8 $5 .125 $8
$8 $8 $8 .125 $8

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