Lecture 4: Auction Theory and Bidding Strategy — How Much Should You Bid to Win?

Auctions as a Game Theory Laboratory

Auctions are an arena where information asymmetry and strategic interaction are on full display. The 2020 Nobel Prize in Economics was awarded to Paul Milgrom and Robert Wilson, the pioneers of auction theory.

The 4 Basic Auction Formats
Type	Mechanism	Real-World Example	Characteristics
English (Ascending)	Highest bidder wins	Sotheby's art auctions	Transparent; competition can escalate
Dutch (Descending)	Starts high, first to accept wins	Flower markets, fresh seafood	Fast; advantageous in low-information settings
First-Price Sealed-Bid	Private submission; highest bid wins and pays that amount	Government procurement, land auctions	Incentive to shade bids below true value
Second-Price Sealed-Bid (Vickrey)	Private submission; highest bid wins but pays 2nd-place price	Some online ad auctions	Truthful bidding is the dominant strategy

The Winner’s Curse

In common-value auctions (e.g., oil drilling rights, M&A), the winner often overpays. Why? The winner is the person who valued the item most optimistically, and that valuation is likely to be an overestimate. This is the winner’s curse.

Winner's Curse — Cases and Lessons
Case	Phenomenon	Lesson
Oil drilling rights auctions (1950s–70s)	Winning firms earned below-market returns on average	Difficulty of estimating common value
Corporate M&A	Acquirer's stock price drops on average post-deal	Synergies were overestimated
US 3G spectrum auctions (2000)	Telecoms over-bid, leading to financial distress	Revenue forecasts for new technology were too optimistic
Job offer salary negotiation	When company's offer is below market rate	Feeling undervalued after joining

Winner's Curse Defense Strategies:
→ In common-value auctions, shade your bid downward
→ Recognize: "If I win, my estimate was the most optimistic"
→ Use independent expert valuations
→ Set your bid based on a worst-case scenario

Optimal Bidding Strategies

Optimal Strategy by Auction Type
Auction Type	Optimal Strategy	Reason
English	Bid up to your true value	No profit in bidding any other way
Vickrey (2nd-price)	Bid your true value honestly	Both over- and under-bidding lead to worse outcomes
First-price sealed	Shade bid below your true value	Secure a margin of profit if you win
Common-value sealed	Discount estimate for winner's curse bias	Correct for the winner's curse

Valuation

Accurately estimate your true maximum willingness to pay (WTP). Avoid overestimating due to emotional attachment or competitive excitement.

Competitor Analysis

Assess the number and information level of competitors. The more competitors in a first-price auction, the closer your bid should be to your true value.

Information Edge

Knowing more about the item than your competitors is your most powerful weapon. Due diligence investment improves the accuracy of your bid.

Set a Walk-Away Price

To remove emotion, set a firm ceiling before the auction — 'I will not go above this amount under any circumstances' — and hold to it even amid bidding excitement.

Reverse Auctions and Procurement Strategy

The reverse of a typical auction — where a buyer forces suppliers to compete — is equally important.

Strategy in Reverse Auctions
Perspective	Buyer's Strategy	Supplier's Strategy
Price Competition	Secure enough suppliers to drive competition	Pre-calculate a cost floor before bidding
Information Disclosure	Disclose that bids are competitive (as leverage)	Recognize that the lowest bid may signal quality concerns
Non-price Terms	Specify quality, delivery, and service requirements	Highlight strengths beyond price
Relationships	Balance short-term low prices vs. long-term partnerships	Be aware of the risk of hidden costs after winning at a low price

Spectrum Auctions Through a Game Theory Lens

Real government spectrum auctions are the biggest real-world stage for auction theory.

Complexity in Spectrum Auctions:
→ Complementarities: Band A and Band B are valuable only together
→ Package bidding: strategy of bidding on individual vs. bundled lots
→ Strategic bidding: bidding to weaken competitors (shill bidding)
→ Combinatorial Auctions: the modern solution

US 5G Spectrum Auction (2021):
→ C-Band (3.7 GHz) auctioned off
→ Verizon, AT&T, T-Mobile participated
→ Total bids exceeded $81 billion

Key Takeaways

Vickrey auction: bid your true value — honesty is the dominant strategy First-price sealed: shade below your true value — secure a winning margin Winner’s curse: the winner = the most optimistic estimator → discount bids in common-value auctions The strongest weapon: information — knowing more than your competitors enables accurate valuation