Effect of Globalization on Business and Profit Making
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Throughout history, profit-making entities (among other) have constructed an ever-more-global economy. In the last 15 years or so, unprecedented changes in communications and computer technologies have given the process new momentum.
Multinational corporations manufacture products in many countries and sell to consumers around the world. Money, know-how and raw materials move ever more rapidly across national borders. Along with products and finances, ideas and cultures mingle more unreservedly.
As globally mobile capital reorganises business firms, it sweeps away regulation and undermines local and national politics. Globalisation creates new spins of old trading ideas (auctions are becoming increasingly prevalent in buying and selling); it starts new markets and it contributes to wealth, even as it causes extensive distress, chaos, and strife. It is both a source of tyranny and a medium for global movements of social integrity and liberation.
Undoubtedly, in the first quarter of the 21st century, the profit-making firm functions in an environment full of global opportunities and threats; and in the wake of recent corporate scandals, the firm, simultaneously, is heavily constrained by ethical self-restraining as well as innovative regulations enforced by domestic and global-governance institutions.
According to A.T. Kearney/Foreign Policy Globalization Index (2003), which is based on indicators such as economic integration, technological connectivity, personal contact, and political engagement (see Table 1 below), from about 1999 to 2003, global foreign direct investment and portfolio capital flows slowed down significantly thus contributing to the weakening of globalisation. Other global trends, especially international tourism, telephone traffic and worldwide access to the internet stayed strong helping to compensate for the weakening of international economic ties, thus deepening global links overall. What are the lessons that the profit-making firm may derive from the globalisation of economic activity?
It appears that global markets, as discussed in the remainder of the section, ‘offer' to the firm less legal restrictions, induce reduction in excess capacity, cause higher market concentration and contribute to higher profits. Consider 1, which links together two 2-dimensional diagrams: one has its origin in the southwest with global concentration measured on the vertical axis and profits on the horizontal; the other has its origin in the northeast with excess capacity measured on the vertical axis and legal restrictions on the horizontal.
As it is discussed below, globalisation enables firms to move ‘northeast' from point A to point B.
Table 1 A.T. Kearney/Foreign Policy Globalization Index (2003)
The 2003 results do not show causation, but they do point to significant correlations; they demonstrate that the most global countries are those where residents live the longest, healthiest lives; women enjoy the strongest social, educational, and economic progress; global integration leads to secularisation. For the third year in a row, in 2003, Ireland ranks as the most global, due to the country's deep economic links and high levels of personal contact with the rest of the world. Western Europe claimed six out of the ten most globally integrated countries in this year's survey. And the USA broke into the top ten, ranking first in the number of secure servers and internet hosts per capita. Countries from Central and Eastern Europe, Australasia, and Southeast Asia also made it into the upper tier (the five most global countries are reported above followed by the top five global firms in Europe and Asia).
· Economic integration: trade, foreign direct investment, portfolio capital flows, and investment income.
· Technological connectivity: internet users, internet hosts, and secured servers.
· Personal contact: international travel and tourism, international telephone traffic, and remittances and personal transfers (including worker remittances, compensation to employees, and other person-to-person and non-governmental transfers).
· Political engagement: memberships in international organisations, personnel and financial contributions to UN Security Council missions, international treaties ratified, and governmental transfers.
1.1 Legal restrictions
As globalisation expands, many firms find themselves (by choice or coincidence) operating in countries that impose less legal business regulations relative to their home countries. Global firms put pressure on local governments to establish more favourable business regulations or refrain from enforcing their regulatory laws (regardless of how minimal or fair they are) or, if such laws do not exist, to avoid applying them. As a result, less regulated or totally unregulated markets reduce barriers on the flow of goods and money across borders, creating a more integrated and profitable global economy.
Over regulation: Business firms in developing nations face much larger regulatory constraints than those in developed nations; as reported in Doing Business in 2005 [World Bank, (2004), p.3],
“(a) they face 3 times the administrative costs, and nearly twice as many bureaucratic procedures and delays associated with them. And they have fewer than half the protections of property rights of rich countries. (b) Heavy regulation and weak property rights exclude the poor from doing business. In poor countiers 40% of the economy is informal. Women, young and low-skilled workers are hurt the most.”
The lowering of over regulatory constraints is actively pursued because it brings benefits to firms (they spend less money and time on dealing with regulations) and to governments (they spend fewer resources regulating and more providing social services). Moreover, fewer regulations attract foreign firms with all benefits and, of course, costs associated with them. Hence, globalisation enables firms to benefit from the removal of unnecessary regulations and the establishing of trade-encouraging, incentive-loaded laws. At the same time though due to ‘global' complexity, the emergence of new innovative technology-driven markets as well as inability of regulatory authorities to enforce the existing legal enactments (reformed or not), some firms, as described below under illicit trade, may avoid compliance with domestic or international laws.
Illicit trade: The fact that, globally, unlawful trade in products and services involving intellectual property, money laundering, third shift production and alien smuggling has been on the rise, implies that authorities in various countries experience hard time in dealing with the problem.
As Naim (2003) writes, intellectual property illegalities, a modern kind of piracy, involves business software, shampoos, motorbikes, medical drugs, industrial valves, supply of illegally copied copyrighted music, and among other, theft of brand names. In Naim's words:
“Governments have attempted to protect intellectual property rights through various means, most notably the World Trade Organization's Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS). Several other organizations such as the World Intellectual Property Organization, the World Customs Union, and Interpol are also involved. Yet the large and growing volume of this trade, or a simple stroll in the streets of Manhattan or Madrid, show that governments are far from winning this fight.”
Additionally, deregulations of financial markets have given rise to rogue global banking, tax havens, and money laundering. All these factors make possible cross-border money transfers, while simultaneously, improvements in electronic technologies make distance less of a barrier and turn money into e-money defined by Naim as “cards with microchips that can store large amounts of money and thus can be easily transported outside regular channels or simply exchanged among individuals.” Naim states that
“estimates of the volume of global money laundering range between 2 and 5 percent of the world's annual gross national product, or between $800 billion and $2 trillion. … The sophistication of technology, the complex web of financial institutions that crisscross the globe, and the ease with which “dirty” funds can be electronically morphed into legitimate assets make the regulation of international flows of money a daunting task” magnified by the introduction of e-money.”
Moreover, according to the United Nations, alien smuggling is the fastest growing business of organised crime. According to Naim, this kind of modern enslavement has become a $7 billion a year enterprise and it involves mostly women and children; and contrary to the efforts made by governments to curtail the problem, especially in the UK, Southern Europe and in the USA, the problem is becoming more difficult and complicated over time. Again, Naim puts it graphically:
“A woman can be “bought” in Timisoara, Romania, for between $50 and $200 and “resold” in Western Europe for 10 times that price. The United Nations Children's Fund estimates that cross-border smugglers in Central and Western Africa enslave 200,000 children a year. Traffickers initially tempt victims with job offers or, in the case of children, with offers of adoption in wealthier countries, and then keep the victims in subservience through physical violence, debt bondage, passport confiscation, and threats of arrest, deportation, or violence against their families back home.”
And of course, intellectual property, humans, and financial capital are not the only products and/or services traded illegally for big profits by global networks. There are also markets in human organs, endangered species, stolen fine art, and deadly industrial waste. The unlawful worldwide trades in all these merchandise and services share numerous essential characteristics such as high-tech innovations, societal and political transformations and open fresh markets. Fast spreading globalisation causes the regulatory environment to become more complex which serves as a cover for opportunistic profit through illicit trade, networks and markets. At the same time, governments are becoming increasingly ineffective in dealing with the problem.
Although the global community attempts to regulate global business activity through entities such as the World Trade Organization (WTO), the International Monetary Fund (IMF) the World Bank (WB), alliances such as the G-7, or the G-20, and treaties such as the Kyoto Protocol, the global business environment, by and large, is becoming gradually freer.
1.2 Global concentration
As legal constraints become wobblier, the power of global firms, in terms of concentration, increases. Widespread merger and acquisition (M&A) activities between already big industrial and financial firms started during the 1990s. The new gigantic corporations, by and large, control a large global market share in their respective industries. The build up in global concentration has sweeping implications for the 21st century. As reported by Mohamed (2004)
“total global mergers activity grew from over $150 billion in 1992 to over $2000 billion in 1998, when eight of the world's ten largest mergers took place. By 1999 it was over $330 billion.”
The enhanced mass and influence of these new giants has been central to the intuition that globalisation advances at a blazing speed. In general, most of these global activities, such as M&A, foreign direct investment and international trade, are between developed nations. Mohamed reports that “this concentration of economic power and activity is clearly illustrated by the fact that over 95% of the companies on the Fortune 500 (ranked by value of sales) and FT (Financial Times) 500 (ranked by market capitalization) lists are developed-country companies. In addition, only a handful of developing-country companies feature on the list of the top 300 companies ranked by expenditure on research and development (R&D). When one considers that developed countries have less than 20% of the world's population then the magnitude of the disparities in the global economy cannot be more evident.”
Escalated global economic concentration was caused by a number of actions. There was a shift towards focusing on core activities that led to unbundling of formerly diversified conglomerates. There were vast investments in knowledge capital, primarily in hardware, software and information technology (IT) services. Much of the R&D outlays of multinational corporations has been on IT, which has helped develop coordination of all aspects of their dealings internationally. There has been globalisation of mass media (e.g., CNN and BBC), which has led to the creation of global franchises (e.g., McDonalds and Wal-Mart), global brands (e.g., Nike) and global marketing infrastructure. The global reach, multiplication and liberalisation of financial markets as well as rapid growth of international capital flows since the 1970s contributed to the growth of multinational corporations. Much of the funds for the new giants came from institutional investors, who prefer big companies that sell popular brands, control large market shares, invest significantly on R&D and focus on their nucleus activities. Additionally, as reported by Mohamed,
“the process of global concentration that started in the 1990s happens not only in leading companies but also upstream in their suppliers and downstream in companies distributing their products. The leading companies have pressured their suppliers and distributors to work more closely with them and to become global leaders in their own areas by also growing through M&As. This process has further concentrated the global economy.”
1.3 Excess capacity
The massiveness of the global market (the market size effect) along with adaptive, flexible and responsive marketing (the marketing effect) enables global firms to sell more. Additionally, they sell at reduced prices because of lower production costs due to outsourcing and insourcing as well as due to new inexpensive technologies such as the internet and the cell phone (the cost effect).
Obviously, market and marketing effects induce firms to reduce their excess capacity but cost effects enable firms to add excess capacity. Whether or not the reduction in excess capacity is in absolute value greater than the increase in excess capacity is an empirical question.
Undoubtedly, global manufacturing is on the rise enabling firms to become more adaptable, more flexible in production and distribution as well as more responsive to the needs of customers; and since the global economy is on the rebound after the depths it reached in 2008/2009, see Table 2, it is perhaps reasonable to believe that rising global demand will contribute to a reduction in excess capacity which, in absolute value, would exceed the increase in excess capacity leading to more profit and, hopefully, to improved global economic well-being.
Finally, as stated by Helpman (2006), in this global economy we have experienced rapid expansion of trade in services and trade in intermediate inputs. With respect to exports [Helpman, (2006), p.590],
“only a small fraction of firms export, they are larger and more productive than firms that serve only the domestic market, and more firms export to larger markets. A small fraction of firms engage in FDI, and these firms are larger and more productive than exporting firms.”
And although according to Helpman (2006, p.591), the theory of comparative advantage, as an explanation of intersectoral international trade, and the theory of imperfect competition, as an explanation of intra-industry trade, are still valid, globalisation brings
“to trade theory a new focus: the organizational choices of individual firms. By focusing on the characteristics of individual firms, the theory can address new questions: Which firms serve foreign markets? And how do they serve them, i.e., which choose to export and which choose to serve foreign markets via FDI? Under what circumstances do they outsource in a foreign country rather than at home? And if they choose integration, under what circumstances do they choose to integrate in a foreign country, via FDI, rather than to integrate at home?”
Table 2 Real projected gross domestic product (GDP) and growth rates of GDP for regions (in billions of 2005 dollars) 2000-2015 GDP
D less US
Annual growth rates
D less US
Notes: W = World; D = Developed nations; D less US = Developed nations less US;
DE = Developing nations; FCP = Former centrally planned nations EM = Emerging market nations.
Source: Data found in World Bank World Development Indicators, International Financial Statistics of the IMF, Global Insight, and Oxford Economic Forecasting, as well as estimated and projected values developed by the Economic Research Service all converted to a 2005 base year. Available at http://www.ers.usda.gov/Data/Macroeconomics/Data/ProjectedRealGDPValues.xls.
1.4 Insourcing and urbanisation in developing economies
Insourcing (incoming foreign direct investment) and outsourcing (outgoing foreign direct investment) have been contributing to net benefits of formal firms in both developed and developing nations and in turn to the well being of all.
Drezner (2004, p.22), in response to rhetoric against outsourcing in the USA, states that
“outsourcing of American jobs to other countries has become a problem of epic proportion. Fortunately, this alarmism is misguided. Outsourcing actually brings far more benefits than costs, both now and in the long run. If its critics succeed in provoking a new wave of American protectionism, the consequences will be disastrous -- for the U.S. economy and for the American workers they claim to defend.”
In developing nations though, insourcing has been transforming local economies in new directions that cause global anxiety. Demographics in China, India and many more economies indicate that populations, in search of jobs and a better life, have been migrating towards urban, industrialised, centres, abandoning their agrarian lands, creating megacities and giving rise to urbanisation-type problems. (See self-explanatory projected population data for China and India in Tables 3 and 4).
Table 3 Urban, rural population trends in China
Source: Available at http://ww2.unhabitat.org/habrdd/conditions/eastasia/china.htm.
Table 4 Megacity population trends in India
Source: Available at http://www.ifpindia.org/ecrire/upload/press_ifp_website/ indiapolis_articlerelu.pdf.
Megacity build-up and abandonment of agrarian lands have been occurring throughout the developing world1. In all these countries, historical data seems to support two stages of development:
In Stage I, prior to insourcing, most of the population lives in the agrarian sector on subsistence agriculture and/or on meagre wages from selling their labour. Overpopulation forces people to exist under perpetually poor conditions causing the supply of labour to be perfectly elastic since there is around abundant low-skilled perfectly substitutable agrarian labour. In general, in this stage of development, the agrarian sector may be described by 2, where A = agrarian, e = equilibrium, WA = wage rate, LA = labour, DA = demand of labour, and LA = supply of labour2. Point V corresponds to the amount of available labour in the sector, point T to the amount of labour employed by the informal economy at equilibrium (point e) and (V-T) to the surplus of labour in the agrarian sector.
Insourcing gives rise to Stage II. Incoming foreign direct investment takes root in urban centres (in most cases near the coast, e.g., China) and offers higher wages to attract labour from agrarian regions. In this stage, the industrial sector may be described by 3, where I = industrial. It is assumed that at We supply of labour in the industrial sector is equal to zero (workers would have no incentive to migrate if they cannot receive higher wages). Equilibrium initially occurs at eI, where DI is equal to SI, and labourers get paid WeI > We. At this market wage rate, the industrial sector absorbs portion TU of the total surplus labour available in the countryside. In turn, because there is still unused surplus labour in the agrarian sector (portion UV), more insourcing triggers higher demand for labour in the industrial sector (DI¢) and migration of the remaining surplus labour; additional migration to urban areas causes the labour supply to become more elastic (the supply function flattens and rotates out to SI¢). At the new and final equilibrium of eI¢, WeI¢ < WeI and the left-over portion of surplus labour, UV, is employed.
The above analysis implies many benefits: employment and income improve; know-how spreads through technology transfer; saving, investment, and tax revenue increase greatly contributing to growth; in addition to the above, people may prefer the city because it is more likely to endeavour entrepreneurial opportunities, find formal education for their children, have access to healthcare, enjoy entertainment, live cosmopolitan lives, and take advantage of proximity to major transposition hubs (for travelling to other countries and inside their own).
However, the analysis implies costs as well, especially as they relate to urbanisation, such as: pollution (air, water and land); crime (especially in inner city areas); traffic jams; crowded housing; loss of arable land; food shortages (since people abandon their agrarian fields in the country and/or because they turn agrarian fields near the city into suburbs); creation and stagnation of an informal economy; lack of socialising due to isolation from, and alienation of, neighbours; deterioration in education (due to capacity limitations) as well as healthcare, transportation and governmental services (especially in utilities, fire and police protection); and finally, dependency on food importation, foreign direct investment and foreign capital markets.
1.4.1 Development views: ‘romantic', ‘parasite' and ‘dual economy'
In addition to the above, urbanisation in developing nations spawns informal business firms, which, in general, do not pay taxes or abide by laws and regulations. According to some economists, such firms do not contribute to the overall growth of the economy. Development economists agree though that registered, law abiding, efficiently run entities known as formal business firms have to be encouraged to exist through incentives and governmental policy for they are the only capable of boosting economic growth and development.
According to the United Nations (2008, p.1), “four billion people around the world are robbed of the chance to better their lives and climb out of poverty, because they are excluded from the rule of law.” Informal business firms account for up to about half of economic activity in developing nations but researchers disagree about their role. As explained by La Porta and Shleifer (2008, pp.275-276), “there are three broad views of this role, (referred) to as the romantic view, the parasite view, and the dual economy - ‘dual' for short - view (otherwise known as the) ‘Wal-Mart' theory of development.”
In the ‘romantic' view, associated with de Soto (2000), informal firms, which are similar to formal (for example, they attract equally talented employees), are held back by barriers to official recognition: lack of secure property titles, deeds, securities and contracts that describe the economically significant aspects of assets. The lowering of such barriers would improve the ability of firms to borrow against registered and secured property-based collateral; additionally, it would enable them to more easily acquire, and/or merge with, other firms.
In contrast, the ‘parasite' view holds that informal firms, led by less-able, mostly uneducated, entrepreneurs, choose to stay small; as such, they lack the needed scale to operate efficiently and, conveniently, they enjoy cost advantages since they do not pay taxes, offer fringe benefits to employees, follow safety requirements in the workplace or abide by other regulations and the rule of law. These firms impair the economy's
growth: they reduce overall productivity and they take away market share from more productive formal firms because of their cost advantage over them. Hence, governmental initiatives to uproot these ‘parasites' (such as enhancing audit capabilities to reduce tax evasion and enforce regulations) would contribute to efficiency, employment, growth and development.
Finally, according to the ‘dual' view, informal and formal firms may coexist as long as government tax and regulatory policies support the development of formal firms without encouraging or discouraging informal firms. Unlike the romantic view, this view holds that formal firms are different than informal: formal firms attract more skilful employees, their owners are better entrepreneurs, they are officially recognised, they can raise capital and they abide by regulations. Unlike the parasite view, the dual view maintains that informal firms are not a threat to formal firms because, for the same products, they charge higher prices (due to inefficient production and thus high costs) and because they mostly operate in different markets selling to different clients.
La Porta and Shleifer (2008, p.278) report that empirical evidence supports the ‘Wal-Mart' theory of economic development and they stress that “the dual view sees the (informal) firms as providers of a livelihood to millions, perhaps billions, of extremely poor people, and it cautions against any policies that would raise the costs of these firms. This view sees the hope of economic development in policies, such as human capital, tax, and regulatory policies, that promote the creation of (formal) firms, letting the (informal) ones die as the economy develops.”
2 The increasing relevance of auctions
Firms may participate in auctions as buyers (bidders) or sellers (auctioneers). As buyers, they want to maximise buyer surplus (the difference between what they would be willing to bid at and the bid they actually pay). As sellers, they want to maximise profit (the difference between the bid they would be willing to sell at and the cost of the auction's object). Although any entity may rely on auctions for selling and buying, a few ‘liaison' firms have become very famous over their valuable and pioneering business concepts. Such firms are Christies, Sotheby's, and eBay.com.
Retail, franchise or land acquisition, government procurement, and various services, among many more, rely on auction-type selling and buying. For example, retail stores (such as Filene's Basement in Boston) report a price on an item's tag but the actual price paid by the client is lower the more time the item is up for sale on the floor;
in turn, unsold items are donated to charitable organisations. Similarly, sellers in fresh produce markets lower prices towards the end of the day prior to disposing off the
items. Governments purchase military assets and/or services of engineers for public infrastructure by relying on bids submitted by the sellers of those services and franchise owners bid for the privilege to own a franchise licence. Home developers, often, buy land in multiple lots through auctions and, of course, eBay has turned every single person on the planet into a potential auctioneer and/or a bidder.
Auction results depend on many factors such as type of auctions or design, information of bidders' valuations (which may be identical or different) and their attitudes towards risk, whether or not bidders bid on many or on a bundle of units and, of course, on whether or not bidders and auctioneers act ethically. For more details and a guide to literature see Klemperer (1999).
2.1 Bidders (or buyers)
Table 5 describes five well-known auction types. Bidders in an English auction would have the incentive to bid higher than other bidders but lower than their true valuation. An advantage to English auctions is that, during the auction, bidders may swiftly revise bids upwards (up to but not higher than whatever they are willing to pay) based on information about the valuations of other bidders in the auction.
Bidders in Dutch and First-Price Sealed-Bid auctions would have the incentive
to bid strategically so that they never lose to someone with a lower valuation of the item under auction. A strategy for the bidder in these auctions would be to shade down the bid to the unknown second highest bid. As explained by Pepall et al. (2005, pp.640-641), each bidder may estimate the second highest bid as follows: assuming that each
bidder in the auction believes that her valuation is the highest, if bidders draw from a uniform distribution [0, υ] with all N bidders equally spaced on this interval (where
υ = highest bid), then the average of the highest value in samples of size N drawn from [0, υ], or the second highest bid, would be [(N - 1) / N]υ. (For example, if there are N = 5 bidders and a bidder's highest valuation is $100, then the second highest valuation is
[(5 - 1) / 5] $100 = $80; hence, the optimal bid for this bidder would be $80). But, if the bidder is wrong on her belief that she is the highest bidder she may lose the auction. Thus, bid shading implies a possible benefit and a possible cost: it may increase the profit margin if the bidder wins the auction and, simultaneously, it may lower the probability of winning.
Table 5 Descriptions of five well-known auctions
“An ascending sequential-bid auction in which bidders observe the bids of others and decide whether or not to increase the bid. The auction ends when a single bidder remains; this bidder obtains the item and pays the auctioneer the amount of the bid.”*
“A descending sequential-bid auction in which the auctioneer begins with a high asking price and gradually reduces the asking price until one bidder announces a willingness to pay that price for the item.”*
First-Price Sealed-Bid auction
“A simultaneous-move auction in which bidders simultaneously submit bids on pieces of paper. The auctioneer awards the item to the high bidder, who pays the amount bid.”*
Second-Price Sealed-Bid (or Vickreya) auction
“A simultaneous-move auction in which bidders simultaneously submit bids. The auctioneer awards the item to the high bidder, who pays the amount bid by the second highest bidder.”*
eBay-type (or Proxy) auction
The eBay internet-type auction is a blend of the English and Vickrey auctions.
Buyers. For an item under auction, a bidder submits two bids: a maximum bid Mi (the value of which is not disclosed to other eBay clients) above which i would not be willing to pay and, simultaneously, a lower bid which is disclosed to all potential bidders. If, at the end of the auction, the highest disclosed bid offered by eBay clients is X < Mi (and Mi is the highest of the non-disclosed values) the item is awarded to i at the price of X.b Sellers. The seller registers two prices: an undisclosed reserve price (the minimum acceptable price) and a starting price - which may be equal to the reserve price or lower to motivate bidding. If a bidder does not meet the reserve price, the seller is not obligated to sell the item. When bidders enter they are informed that the auction has a reserve price and whether or not it has been met.b
Notes: * Definition found in Baye and Beil (1994, pp.467-480).
a Vickrey (1961).
b For more details browse http://pages.ebay.com/help/sell/ (eBay, 2006).
Bidders in Second-Price Sealed-Bid and Proxy auctions have the incentive to bid honestly. Consider the following example: Let B be a bidder with the highest valuation of $300; $300 is B's true value.
* If B bids $400 and the second highest bid is $200, B is awarded the item for a profit of $100 (but, a bid of $300 generates the same amount of profit). If B bids $350 and the second highest bid is $325, B is awarded the item but at a loss of $25. B, in this case, experiences the winner's curse. Hence, there is no incentive to bid above $300.
* If B bids $250 and the second highest bid is $200, B makes a profit of $100 (the same profit that would result from the truthful bid of $300). But, if B bids $250 and someone else bids $270, B loses the auction. Hence, there is no incentive to bid below $300.
For illustration, consider Table 6, which displays the frequency of bidders per bid. Assume that there are eight risk-neutral bidders (bidders who bid exactly their valuations) named B1, B2,…, B8; each bidder has a private valuation for a certain item to be auctioned off and believes that her valuation is the highest; out of all, bidder B4 is the one with the highest valuation at $40; bidding starts at $15 (in an English auction) or $50 (in a Dutch auction) and bids change by an increment of $5.
* In an English auction, B4 wins at $35 and makes a profit of $5.
* In a Dutch auction, B4 wins at [(N - 1) / N]υ = [(8 - 1) / 8]40 = $35 and makes a profit of $5.
* In the First-Price Sealed-Bid auction, like in the Dutch auction, B4 wins at
[(N - 1) / N]υ = [(8 - 1) / 8]40 = $35 and makes a profit of $5.
* In the Second-Price Sealed-Bid auction, B4 bids $40, pays $35 and makes a profit of $5.
* In the eBay-type auction, like in the Second-Price Sealed-Bid auction, B4 bids $40, pays $35 and makes a profit of $5.
Table 6 Private valuation auction illustration
Thus, regardless of auction type, the winning bid is the same. This result has been labelled, the Revenue Equivalence Theorem [for details see Vickrey (1961) and/or Lucking-Reiley (2000)]. According to a simple version of the Theorem, all auctions described in Table 6 generate the same expected price equal to the valuation of the second-highest bidder.
2.2 Auctioneers (or sellers)
Auctioneers, naturally, would not desire to sell below their reserve prices; to assure themselves the maximum possible gain, they must study the expected outcomes of the different types of auctions before they choose the profit maximising type. Such a choice depends on what and how bidders think and/or feel. Do other bidders influence them during the auction? Do they feel optimistic? What are their risk preferences and the information structure within which they make decisions? How many bidders are in the auction? What is the state of the economy?
2.2.1 Risk preference
Bidders may be risk-neutral or risk-averse.
1 A risk-neutral bidder is indifferent between a certain profit of $X and an expected profit of $X via risky gambling. The objective of risk-neutral bidders is to maximise expected profits.
2 A risk-averse bidder prefers a certain profit of $X to an expected profit of $X via risky gambling. The objective of risk-averse bidders is to win the auction; as bids approach their true valuations, they are more willing to accept higher bids, especially the greater the number of bidders in the room.
2.2.2 Information structure
Perfect-information auction: bidders in an auction may have perfect information about the item being auctioned. For example, if a $10 bill were to be auctioned off, every bidder would know that the item is worth $10 to each competing bidder.
In auctions with perfect information, because a bidder's valuation does not affect the valuations of other bidders in the auction, risk preference is irrelevant. Therefore, each one of the auctions described in Table 5 generates the same amount of revenue.
Common-value auction: alternatively, a bidder may want to participate in a common-value auction by offering an estimated bid about the value of the item under auction. For example, let the item for auction be a bag full of dollars (valued identically by all bidders) but assume that bidders do not know the number of dollars in the bag. To proceed in this auction, bidders can only submit bids based on estimated values, which, of course, make them susceptible to the winners' curse: the bidder may pay more than the item is worth. The bidder with the highest estimated value does not have a higher chance of being correct relative to any other. In reality, bidders do not know the valuations of co-bidders but, if they did they could compute the average of these valuations and thus come up with a more precise estimate of the item's true value. For instance, if the auctioneer announces that the bag's value is between $10 and $20, five bidders, drawing from the interval ($10-$20) may come up with the following estimates: $13, $15, $16, $18, $12 - where $18 is the Optimist's valuation. Hence, if bidders bid their estimates, the bag is awarded to the Optimist at $18. If the bag contains $15, the Optimist, by paying $3 over the real value of the item, experiences the winners' curse. Notice, in this example, that the average of all submitted bids ($14.8) is closer to the true value of the item.
The best defence against the winner's curse is to shade down the bid. A possible shading strategy is outlined in Pepall et al. (pp.643-645): assuming that each bidder in the common-value auction believes that her valuation is the highest, if bidders draw from a uniform distribution [0, υ] with all N bidders equally spaced on this interval (where υ = highest bid), then the average of the highest value in samples of size N drawn from [0, υ], or the second highest bid, would be [(N - 1) / N]υ. Thus, if a bidder's highest valuation is υh, then υh = [(N - 1) / N]υ which implies the estimate υ = [N / (N - 1)]υh. For example, using the numerical illustration of the previous paragraph with N = 5 and υh, the Optimist's estimate for υ is υ = [N / (N - 1)]υh = (5 / 4)18 = $22.5. Therefore, from the interval [0, υ] = [0, $22.5] the implied mean is $11.25 which is Optimist's best estimate of the true value of the contents of the bag, of course much lower than the original value of $18. Since all bidders are assumed to compute their bids as Optimist does, then each shades down bids the same way. As before, Optimist wins the auction and, depending on the true value of the item, with gains or minimum winners' curse losses. In the above numerical example, Optimist gains ($15 - $11.25 = $3.75). If the true value of the item were lower than $15, the gains, or the winners' curse losses, would be smaller.
In common-value auctions, bid shading, to minimise the winners' curse, reduces the auctioneer's expected revenue and, because a bidder's valuation is affected by the valuations of other bidders in the auction, risk preference matters. Naturally, risk-averse bidders would shade down bids less than risk-neutral bidders. In English auctions, regardless of risk preferences, bidders scrutinise the upward moving bids and they derive inferences about the valuations of their co-bidders; in turn, if they are still in the hunt, they amend their own bids upward towards their true valuations; naturally, their willingness to amend upwards increases with the number of bidders. English auctions, potentially, should generate higher revenues for auctioneers than simultaneous auctions.
Private-value auction: another auction in which a bidder may want to participate in is a private-value auction in which different bidders value a certain item differently. For example, if the item under auction is a Picasso piece bidders know their own private valuations for the painting but not those of others; in other words, bidders' valuations are not correlated.
Obviously, with risk-neutral bidders, auctioneers would derive the same amount of revenue for any of the auctions in Table 5.
Risk-averse bidders, due to fears of getting outbid, would have less incentive to shade their bids and, as a result, auctioneers should expect more revenue from Dutch and
First-Price Sealed-Bid auctions. But, auctioneers should expect less revenue from English, Second-Price Sealed-Bid or eBay-type auctions since in these auctions bidders do not have to estimate what the second highest bid will be.
2.3 Other actions
All-pay actions: an all-pay auction is a First-Price Sealed-Bid auction in which all participating bidders pay to the auctioneer the amount they bid. In turn, the item under auction is awarded to the highest bidder. Undoubtedly, due to bidders' misestimating and excess bidding, this auction has the potential to generate significant revenues for the seller. Consider an illustration based on a perfect information auction: let 30 students in a classroom participate in an auction for a $10 bill owned by the auctioneer; each student, should privately decide how much to bid, enclose the dollar amount in an envelope and then deliver it to the auctioneer. In turn, the auctioneer would award the prize to the highest bidder. What would be a possible bidding strategy? According to Dixit and Skeath (2004, p.549), if all N bidders bid on average V/N each (where V = value of item under auction) overbidding is eliminated, the total expected bid is (V / N)N and the auctioneer realises zero revenue. Notice that if each bidder bids V/N, then all of them win in which case they split evenly the prize. According to Dixit and Skeath (2004, p.549) “unfortunately, many people in actual all-pay auctions either do not know or forget this theory and bid to excess.”
Bidding in excess would generate revenue for the seller and possibly profit. In the above example, if ten students bid $1each, 15 students bid $0.50 each, four bid $0.70 each and one bids $2, the auctioneer's revenue and profit will be, respectively, $22.3 and $12.3. The item will be awarded to the highest bidder who would realise a profit of $8 whereas all other bidders would experience losses equal to their bids. Alternatively, to secure a certain level of profit (ΠC), the auctioneer may start the auction at (or not accept less than) a minimum bid of ‘M' such that (M)N = ΠC > V. In the above example with N = 30 and V = $10, if D = $0.4, the auctioneer's profit would be at least $2. Obviously, overbidding increases the auctioneer's revenue but it may also benefit, monetarily and psychologically, the bidder: if a student bids $12 and wins the auction she would realise a loss of (-$2) and the pleasure of winning; but if she bids $7 and loses the auction, she would realise an even bigger loss of (-$7) and, of course, the displeasure of losing.
The above example is based on a ‘perfect-information' auction but under certain conditions (for example, if the value - or range of values - of the object is low, or if the auction is for a non-material object) pay-all auctions may be used for ‘common-value' or ‘private-value' objects. Consider the following examples offered by Dixit and Skeath (2004, p.548):
“In political contests, all candidates spend a lot of their own money and a lot of time and effort for fund raising and campaigning. The losers do not get any refunds on all their expenditures. Similarly, hundreds of competitors spend 4 years of their lives preparing for an event at the next Olympic games. Only one wins the gold medal and the attendant fame and endorsements; two others win the far less valuable silver and bronze medals; the efforts of the rest are wasted.”
Perhaps an all-pay auction may be appropriate for the generation of revenues for charity or for public projects for which the bidder, win or lose, receives a tax deduction. Such auctions, of course, compared to lotteries or raffle-ticket drives, may entail prohibitively high administration costs.
Yankee auctions: a Yankee auction is a Multiple-Identical-Objects auction. The auctioneer specifies the minimum starting bid and the quantity of objects available. Bidders bid on price and quantity; additionally their time of bidding is recorded. The auctioneer awards the object to the highest price bidder and if there is a tie, to the highest quantity bidder; if there is a two-way tie in price and quantity, the object is awarded to the bidder who submitted the bid the earliest. If a bidder wins on price and wants to acquire a certain number of objects but there are fewer objects available, the bidder is expected to purchase the lesser quantity.
For example, 15 identical objects are up for an auction with a starting bid of $60; the top five bidders, A, B, C, D and E bid as follows:
Time of bidding
Notes: First, C is awarded 5 objects at $80; second, E is awarded 5 objects at $80; third, B is awarded 4 objects at $70; D is awarded 1 unit at $70 (2 less units than desired); A, although willing to pay as much as D, does not even qualify for the leftover unit due to late filing.
In some Yankee auctions, units are auctioned off in bundles instead of separately. For example, a 10-acre parcel of land may be offered in its entirety (all 10 acres) or in 5 subsets (2 acres each). Whether or not the seller will auction off the entire 10 acres or the subdivisions depends on what bidders plan to do with the land. If bidders are developers and they need the land for a housing community, they would rather bid for the entire 10-acre lot because it will require less transaction costs and offer certainty over lot size - big enough for the realisation of economies of scale, parking, etc. If bidders were people who want to buy land for their own homes or for investment, they would rather bid for one or more 2-acre lots instead of the entire 10 acres. For more on auction design, see Klemperer (2002).
2.4 Ethical issues
In an effort to curb possible opportunistic behaviour by auctioneers and bidders, facilitating entities, such as eBay and auction houses, as well as institutions, such as the National Auctioneers Association (NAA) and the Federal Trade Commission (FTC), both in the USA, have been identifying fraudulent tactics and establishing protective mechanisms against them.
Auctioneers may call bids that were never made (called phantom bids) to induce additional competition among bidders. Such a deceptive tactic, potentially, may raise revenue for the seller and perhaps commission for the auctioneer. According to the FTC (2006),
“Among the thousands of consumer fraud complaints the FTC receives every year, those dealing with online auction fraud consistently rank near the top of the list. The complaints generally deal with late shipments, no shipments, or shipments of products that aren't the same quality as advertised; bogus online payment or escrow services; and fraudulent dealers who lure bidders from legitimate auction sites with seemingly better deals. Most complaints involve sellers, but in some cases, the buyers are the subject.”
For more details see Table 7, which contains information found in FTC's (2006) website.
Table 7 Types of fraud and fake checks
Types of fraud
Most people who complain to the FTC about internet auction fraud report problems with sellers who:
· fail to send the merchandise
· send something of lesser value than advertised
· fail to deliver in a timely manner
· fail to disclose all relevant information about a product or terms of the sale
Some buyers experience other problems, including:
· ‘Bid siphoning', when con artists lure bidders off legitimate auction sites by offering to sell the ‘same' item at a lower price. They intend to trick consumers into sending money without delivering the item. By going off-site, buyers lose any protections the original site may provide, such as insurance, feedback forms, or guarantees.
· ‘Second chance offers', when con artists offer losing bidders of a closed auction a second chance to purchase the item that they lost in the auction. Second-chance buyers lose any protections the original site may provide once they go off-site.
· ‘Shill bidding', when fraudulent sellers or their partners, known as ‘shills', bid on sellers' items to drive up the price.
· ‘Bid shielding', when fraudulent buyers submit very high bids to discourage other bidders from competing for the same item, then retract their bids so that people they know can get the item at a lower price.
Escrow service complaints. Another type of fraud occurs when sellers or buyers pose as escrow services to improperly obtain money or goods. The so-called seller puts goods up for sale on an internet auction and insists that prospective buyers use a particular escrow service. Once buyers provide the escrow service with their payment information, the escrow service does not hold the payment: It is sent directly to the so-called seller. The buyer never receives the promised goods, cannot locate the seller, and, because the escrow service was part of the scheme, cannot get any money back.
In some cases, a fraudster poses as a buyer and, after placing the highest bid on an item, insists that the seller use a particular escrow service. The escrow service tricks the seller into sending the merchandise and does not send the payment or return the goods to the seller.
Fake check scams target sellers
Sellers can be victims of fraud when buyers send fake checks or money orders that are detected by the bank only after the seller has shipped the goods. A buyer might offer to use a cashier's check, personal check, or corporate check to pay for the item you are selling. Sometimes, the buyer sends a fake check or money order that exceeds the cost of the item that has been purchased. The so-called buyer (or the buyer's ‘agent') states that he made a mistake, or comes up with another reason for writing the check for more than the purchase price. In either case, the buyer asks you to wire back the difference after you deposit the check. You deposit the check, learn that it has cleared, and wire the funds back to the ‘buyers'. Later, the bank determines that the check is fraudulent, leaving you liable for the entire amount. The checks were counterfeit, but good enough to fool unsuspecting bank tellers.
Source: FTC, available at http://www.ftc.gov/bcp/conline/pubs/online/auctions.htm.
The NAA has established a code of ethics and standards of practice that describe, “obligations higher than those mandated by law” (NAA, 2006).
Additionally, as reported by Pepall et al. (2005, p.645) “eBay polices militantly against tactics aimed at cheating either sellers or buyers. (Against shill bidding rings, it) employs over 800 monitors to detect such rings and has strict retraction rules that make this ruse difficult to use. Anyone caught in this practice is banned from eBay.” Also, as per eBay practice, buyers get to rate the products and sellers; these ratings, in turn, become available information to all bidders making them less reluctant to bid on items and/or more willing to bid high.
In conclusion, auction results depend on many factors such as type of auctions or design, information of bidders' valuations (which may be identical or different) and their attitudes towards risk, whether or not bidders bid on many or on a bundle of units and, of course, on whether or not bidders and auctioneers act ethically.
The main lessons drawn from the above analysis are as follows:
1 Expected revenues for auctioneers or sellers are determined by information structure and the risk preference of bidders. In pursuing revenue maximisation, sellers ought to be aware of the Revenue Equivalence Theorem, according to which perfect-information auctions (irrespective of bidders' risk preference) or private-value auctions (for risk-neutral bidders), regardless of design, generate the same revenue.
2 Bidders or buyers want to avoid the winner's curse subject to, among other strategies, bid shading. Additionally, in Second-Price Sealed-Bid (or Vickrey) auctions, truthful revelation of bids is a dominant strategy.
3 Bidders, auctioneers and liaisons are exposed to a variety of unethical or illegal acts against one another, a problem that becomes increasingly bigger with globalisation.
As eBay and many smaller competitors continue with their strong performance in terms of both profit-making for themselves and benefits offered to buyers and sellers, it appears that the auctions industry has become a force to reckon with. The NAA believes in the industry's prevalence and exponential growth; as the Association's vision statement states (NAA, 2006),
“Competitive bidding will be increasingly utilized as a method to sell all types of goods in all segments of the economy. The National Auctioneers Association (NAA) will unify and lead the competitive bidding industry to fulfill this vision.”
3 Ethical constraints
In the aftermath of the recent corporate scandals in the USA and other countries, the firm is concerned with business ethics more than ever. Profit-making entities have become minimisers of unethical calamities. As evidence amounts, it is to the firm's strategic advantage to incorporate preventive mechanisms against ethical mishaps and to undertake swift and effective damage control when such mishaps transpire. Subject to different perceptions on what is ethical in various circumstances, stakeholders are increasingly holding firms accountable for ethical behaviour or performance.
Adam Smith, of course, as early as 1776, had seen the importance of market ethics and prescribed that only non-opportunistic self-interest (or self-interest without guile) would lead to common good. As explained by, among others, Wilber (2004), Evensky (1993) and Kantarelis et al. (2000), according to Smith, common good maximising,
non-opportunistic self-interest, requires
1 that markets are sufficiently competitive
2 that most citizens have internalised universal moral commandments as a guide for their actions.
Smith believed most people, most of the time do act within the guidelines of internalised universal commandments and that those who do not could be dealt with by peer pressure, culture and the state's legal system.
Petrick and Quinn (1997, pp.44-45) define business ethics as “the descriptive and normative study of moral awareness, judgment, character, and conduct as they relate to all levels of (business) practice.” And, as the same authors stress (p.45), although ethical concerns complicate the firm's decision-making process, “handling of moral complexity is required of ethical (firms).”
More generally, profit-making firm ethics is a code of conduct that deals with the appropriateness or inappropriateness of business objectives (ends) and the methods (means) utilised to obtain these objectives. Examples of objectives are, among other, profit-making; growth; lawfulness; fairness; harmony with society, nature, art and state. Examples of methods are, among other, ambition and hard work; responsibility; rationality; innovation; market segmentation marketing; competence; open-mindedness; discipline, independence and self-reliance. Although, within and between firms, setting objectives is of paramount importance, it is not as difficult as choosing methods to achieve these objectives.
Ethical sensitivities depend on:
* individual standards (shaped by a person's phase of moral development and a person's philosophy of life as to what is real, true and of value)
* firm standards (Does an organisation have in display an ethical code that credibly claims values above the legal minimum?)
* legal standards (Often do they exist and, if they do, are they transparent and enforceable? Does enactment of new laws and regulations take place?)
* societal standards (collective values and their impact in shaping group principles for tolerable conduct).
Firms, generally, rely on various theories of ethics for guidance. Petrick and Quinn classify these theories into four groups: teleological, deontological, virtue and system development. The analysis that follows is based, mostly, on Petrick and Quinn, on Hitt et al. (1983) and other sources.
3.1 Teleological ethics
A teleological ethical system seeks to define the proper telos (goal or end) of an entity. According to teleological ethics, the firm's ethical actions that maximise stakeholder net benefits are the ones to be undertaken; the goodness of an ethical choice depends, positively, on stakeholder net benefit or,
The firm may choose to behave as an enlightened egotistical entity, a utilitarian entity or a eudaemonistic entity.
According to Petrick and Quinn (1997, p.47), an enlightened egotistical entity “may well avoid cheating and support community projects, not so much because these actions benefit others, but because they help achieve some ultimate goal for the egoist, such as social image enhancement” or good will and reputation.
The utilitarian firm may subscribe to the classical view or the modern view of social responsibility. In the words of Hitt et al. (1983, pp.516-517),
“(t)he leading advocate of the classical viewpoint of organizational social responsibility is economist Milton Friedman. Friedman argues that social responsibility by business is achieved through maximization of profits. Classicists hold that an organization's profits are invested in self-interest projects to make even more profits. These investments create jobs and demands for other products which, in turn, create more jobs and increase the economic well-being of all individuals in our society. This is an enormous social contribution by profit-seeking organizations.”
Classical utilitarian profit-making entities see a negative association between their profits and their spending for social projects: if firms invest more on social projects, they would invest less on product development and market research which in turn may force firms to invest less in job-creating projects, cause consumer prices to rise (market output to fall) and profit to decline.
Modern utilitarian firms prefer to undertake activities that directly help the larger numbers in society. In the words of Hitt et al. (1983, pp.516-517),
“(m)odernists argue that the true social responsibility occurs when (firms) adopt activities that go beyond profit maximization to benefit society in other ways. …(In general,) to provide the maximum good or the maximum good for the greatest number.”
In other words, an action is ethical when it creates the maximum amount of utility for the maximum number of stakeholders affected by the action. For example, in the beginning of the 20th century, custom-made cars were expensive, purchased only by the upper income classes. In 1907, Henry Ford decided to create a car for the great masses. After five years of trial and error, the Ford Motor Company came up with the first moving assembly line ever used for large-scale manufacturing. The results were lower (affordable) car prices at higher quality, higher sales as well as higher profit. Ford deliberately raised workers' wages to $5 a day (an outstanding wage for the times) since according to him workers were also potential consumers. Hence, sales went up not only because of lower prices but also because of Ford employees' higher incomes. Moreover, higher sales, income and profit contributed to higher tax revenues used, in turn, for the financing of important public goods and services.
A firm's actions may be subject to eudaemonism. According to Petrick and Quinn (1997, p.49) eudaemonism is a “teleological theory that holds that an action is good if it promotes or tends to promote the fulfillment of goals constitutive of human nature and its happiness.” For example, a profit-seeking entity makes an attempt to maximise happiness for its employees when it pushes for higher employee productivity subject to safety and ergonomic standards, non-discriminatory (gender, racial or other) policies as well as subject to sharing of costs in association with health, life-long education and financial security after retirement.
3.2 Deontological ethics
Deontological ethics calls for completing duties in a responsible manner, for obeying the law and following guidelines and, in general, for doing what is morally the right thing regardless of costs or benefits, independent of consequences. Major categories of deontological ethics are ethics associated with positive and negative rights, social contracts and socia
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