Application of Auction Theory Principles on the Sale of a House

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8th Feb 2020 Economics Reference this

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This essay will discuss the application of auction theory principles on the sale of a house. The essay will show the advantages and the apparent limitations of different auction theories. The essay will then conclude to which auction system should be used for the sale of the house. The auction theory models will be critically assessed and analysed to see whether they affect the sale value of the house in an auction.

In economics, auction theory deals with the operations of auction markets including the researching of properties found or available in the auction markets (Mughal, 2011). An auction as a design of sales is composed of a variety of set of rules and designs. Auction theorists focus on things such as the efficiency of a given auction design, revenue comparison, as well as the optimal and equilibrium bidding strategies. The design of real-world auctions is actually informed by the use of auction theory. Traditionally, the allocation of a single item utilizes four types of auctions. These auctions include the English auctions (Open ascending-bid auctions), Dutch auctions (Open descending-bid auctions), Vickrey auctions (Second-price sealed-bid auctions), and the First-price sealed-bid auctions (Nakajima, 2011). These auction theory principles can be applied to the design of sales for any given type of merchandise. In the market, the auction has become one of the most appropriate tools for disposing of merchandise to the prospective buyers hence the development of the auction theory principles. Houses form one of the goods that can be transacted by a way of auction considering their value in the market. The different types of houses that befit auction as a transaction mode include public houses that require privatization as well as houses owned by mortgage defaulters, among other examples. The paper discusses the application of auction theory principles to the design of sales for houses.

English Auctions (Open Ascending-Bid Auctions)

This type of auction is considered an open-outcry ascending dynamic auction (Stevenson and Young, 2015). It is executed in a series of steps. To open the auction to the prospective customers, the auctioneer announces a suggested opening bid, which serves as the reserve or the starting price for the goods on sale. Once the auctioneer suggests the opening price, the floor reciprocates by announcing their preferred prices for the merchandise in an increasing manner (Stevenson and Young, 2015). The increased fashion of the customers preferred prices is attributed to the fact that they are in a competition to win the bid and the highest bidder normally wins the bid. At any given moment in the auctioning process, the standing bid is considered to be owned by the person with the highest bid at that specific point in time. The standing bid then keeps on changing upon the displacement of the current standing bid by a higher bid from a competing buyer. Each standing bid is given a certain period within which the bid can be challenged by another competing buyer. If the allocated time frame for the standing bid during the auction process elapses without being challenged, then the standing bid becomes the winner of the auction and the merchandise is given to the owner of the standing bid at a price equal to his or her bid. The fact that the identity of all bidders is not anonymous, English auctions are considered to be “open” or fully transparent (Stevenson and Young, 2015).

English auctions can be applied to the design of sales for houses. Some of the houses categories that befit the English auctions principle of auction theory include the confiscated houses meant to recover financial dues owed to a given party by another party. Nonetheless, the auctioning party should seek authorization to do so from the relevant authorities to avoid the infringement of the rights of the other party (Jehiel, 2011). In this case, the opening price by the auctioneer should be carefully determined by professional property value assessors to ensure that there is no chance of selling the house under auction at a price that is way below its actual value and one that would not enable the auctioning party to recover its monetary value. In English auctions, the value of any bid above the reserve price is not limited hence there is no revenue equivalence. Due to asymmetric information, the winner’s curse may result when the quality of the merchandise is lower than expected. The end price is therefore higher in relation to value.

Dutch Auctions (Open Descending-Bid Auctions)

Unlike the English auctions, Dutch auctions begin with a high opening bid and then the auctioneer systematically lowers the bid price until a prospective buyer agrees to a certain price lower than that of the opening bid. However, there is a predetermined reserve price for the merchandise under auction, one which the auctioneer cannot lower the bid price below it (Pradhan, 2010). Due to its bidding approach, Dutch auctions principle of auction theory is also referred to as open-outcry descending-price auction. This type of auction is most suited for merchandise that requires urgent disposal since it technically requires only one bid for the sale to take place (Pradhan, 2010). In comparison to the English auctions, Dutch auctions tend to limit the amount of money that the auctioning money can sale the merchandise under auction to a prospective buyer. In English auctions, the competing buyers continue placing higher bids in an increasing fashion hence increasing the chance of selling the item under auction at an incredibly higher price. Therefore, Dutch auctions tend to limit the amount of money that can result from the auction of any given property. This aspect also gives prospective buyers to own the merchandise under auction without being outcompeted by other buyers since the first buyer who places any bid that is below the opening price but higher than the reserve price wins the bid.

Applying the Dutch auctions principle of auction theory to the design of sales of houses, government houses or houses from any other organization or party not interested in making a profit are most suited. According to Katok and Roth (2014), it would be wise for any given party to apply Dutch auctions over English auctions in disposing of a property if no profits are expected to be made from the property’s auction since the former saves on time as opposed to the later. In many cases, governments operate as a not-for-profit organization hence necessitating the use of the Dutch auctions in the event government houses are to be auctioned to the public or being privatized. This aspect would give the prospective buyers a chance to obtain such houses from the government at reasonable prices, which are not exploitative in nature. There is revenue equivalence in Dutch auctions since the highest price payable in the auction is limited. The owner has more knowledge about the houses hence there is information asymmetry. The winner’s curse in this case results when the value is lower than expected hence inflating the end price.

Vickrey Auctions (Second-Price Sealed-Bid Auctions)

This auction theory principle is a type of a sealed-bid auction (Mishra and Parkes, 2015). In Vickrey auctions, the bid of every prospective buyer for the merchandise under auction is anonymous to another bidder since the bids are submitted a written form which is considered to be a confidential form. Unlike the other types of auctions, the highest bidder in Vickrey auctions wins the bid but the merchandise is sold to him or her at a price equivalent to the bid price of the second-highest bid (Mishra and Parkes, 2015). The fact that Vickrey auctions give the bidders an incentive to bid their true value is strategically related to the English auctions principle of auction theory. Vickrey auctions give the bidders an opportunity to arrive at their own private values for the merchandise under auction thereby maximizing their expected utility. This aspect thereby reveals the genuine valuation of different prospective buyers to the item under auction. Since Vickrey auctions are decision efficient, it gives a model considered to be the baseline for posting the efficiency properties of other types of auctions. Nonetheless, when the buyers or the bidders are not certain about their own valuations, Vickrey auctions has the weakness of not allowing for price discovery. Since the bidding process is confidential, Vickrey auctions can suffer from bidder collusion where the bidders can lower their valuations while reserving their favourite bidder to win the auction (Mishra and Parkes, 2015).

In designing the sales for houses, Vickrey auctions can be applied to houses that are brand new to the market and whose price valuation has not been done. According to Kagel and Levin (2014), confidential valuation of any given property gives a person the opportunity to maximize his or her expected utility for the property hence helping in the projection of the suitable price for that property in the market. Based on this aspect, Vickrey auctions can be used to help in determining the actual valuation of houses in any given market by allowing the bidders to maximize on their expected utility hence providing their genuine valuation for the houses under auction. Vickrey auctions can, therefore, be used to establish the pricing for houses in any given market without considering the instances where the auction principle succumbs to bidder collusion hence leading to the undervaluation of the houses under auction. The price payable is equivalent to the value of the second-highest bid hence the revenue equivalence theory applies. Information asymmetry results due to the owner’s knowledge of the merchandise than the bidders. In this case, there is no winner’s curse since the price paid is lower than the highest bid price hence the end price is not inflated in comparison to value.

First-Price Sealed-Bid Auctions

This auction theory principle is closely associated to the Vickrey auctions except that the highest bidder wins the bid but in this case, he or she pays the amount of the highest bid rather than that for the second-highest bid (Katok, 2004). Just like in the Vickrey auctions bids placed in first-price, sealed-bid auctions are considered to be blind and hence confidential. This aspect is because the bidders place their bids in a sealed envelope and submit them to the auctioneer simultaneously at the same time. There is no opportunity for any bidder to know the amount the other bidder is bidding for the merchandise under auction until all the bids are made public by the auctioneer. At this point in time, the auctioneer then determines the highest bid and declares the owner of the bid as the winner.

Applying the first-price sealed-bid auctions to the design of sales of houses would require the predetermination of the reserve price of the houses under auction. This aspect is so because without regulating the minimum value acceptable for the houses under auction would lead to the undervaluation of the houses during the sale. According to Chow and Ooi (2013), auctioneers should observe maximum caution while applying any type of auction theory principle to avoid selling the product under auction at a price that is below the reserve price. In this circumstance, the theory of revenue equivalence does not apply since the bids are confidential. In addition, the owner has more information regarding the houses hence there is information asymmetry (only they know how much they value the merchandise). Winner’s curse may result if the value of the houses is lower than the bidders expect hence giving mistaken valuation. This aspect affects the end price by paying too much money for relatively low quality houses making the buyer loose out.

Conclusion

Due to different nature of different goods, different auctions designs have been developed depending on the efficiency of a given auction design to a specific type of merchandise, revenue comparison, as well as the optimal and equilibrium bidding strategies. The design of sales of houses, the English auction recognizes the highest bidder and without any limitation to the highest amount, that one can bid hence the principle is suitable for making profits. The Dutch auctions put a limitation to the highest payable amount possible hence; it is suitable when necessary for disposing of houses for urgency needs. Vickrey auctions employ a confidential bidding process, which allows for the genuine valuation of the houses under auction by the prospective buyers.

Word Count 2046

References

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