# Auction Theory Basics

Auctions are allocation mechanisms^{1}.

In an auction, each bidder $\mathscr B_i$ decides on a valuation $v_i$ of the object $\mathscr O$ and bid with a bidding price $b_i$ based on the valuation.

The rules may be very different in different actions but they should have two components, how the object is allocated (**allocation rule**) and how the bidders are paying (**payment rule**). A simple yet interesting example of the payment rule is that of a Vickrey auction. Vickrey auction is a type of sealed-bid auction or blind auction, where the bidders have no information about the bidding price of other bidders. In a **Vickrey auction**, the winner pays the **second-highest price**^{2}.

In general, we will observe that an auction has

- the winner $\mathscr B_w$ who takes the object $\mathscr O$,
- the losers $\mathscr B_l$,
- the winner’s payment $p_w$,
- the losers’ payment $p_l$.

In the above bullet points, 1 and 2 are determined by the allocation rules, while 3 and 4 are determined by the payment rules.

In auction theory, it is important to understand what the auction leads to, aka the equilibrium. To achieve this, we will come up with a formal representation of an auction in the following sections.

## Game, Mechanism, and Auction

The Bayesian game provides a good theoretical ground for auctions. A Bayesian game is defined by the setting and the mechanism. The setting is the stage and different mechanisms lead to different equilibria and properties.

The fact that auction is an allocation mechanism indicates that the outcome will be two parts, the **allocation** of the object $X$ and the **payment** $\mathbb{R}^n$ in an $n$ bidder auction. Comparing to the Bayesian game, we have the stage

- $n$ bidders $\{\mathscr B_i\}$ as the agents,
- the allocation $X$ together with the payment $\mathbb{R}^n$ are the outcomes,
- the valuation structures are the types,
- the probability distribution of the valuation structures is the common prior,
- utility functions of the bidders as the utility functions.

We also have the mechanism

- bidding at different prices as actions,
- allocation rule (or choice rule) and payment rule map the actions to the allocation results $X$ and payment results $\mathbb{R}^n$, respectively.

## Risk Attitude

Technically speaking, the valuation $v_i$ doesn’t necessarily equate to the bidding price $b_i$ of bidder $\mathscr B_i$. The relation between valuation $v_i$ and bidding price $b_i$ is called the **bidding function**.

The payoff of $\mathscr B_i$ who bids with $b_i$ and valuation $v_i$ is $v_i - b_i$. The simplest definition of the utility function is

$$ \begin{equation} u_i = v_i - b_i. \label{eqn-auction-utility-payoff} \end{equation} $$Notice that this utility function only depends on the choice of the bidder. Though useful, this definition doesn’t reflect the personalities of the bidder. For the personalities, we introduce a new term related to the payment $p_i$, so that the utility becomes

$$ \begin{equation} u_i = v_i - b_i - f_i, \label{eqn-auction-utility-payoff-and-payment} \end{equation} $$where $f_i$ is a function of the payment. The risk attitude is best tested in a fair lottery where the expected payoff is the same as the investment. In such a fair lottery, the utility for \ref{eqn-auction-utility-payoff-and-payment} depends on the payment and the willingness to pay is different at different costs.

Risk neutral bidders are willing to participate at different payment based on payoff. Risk aversion bidders are less willing to participate at higher payment and risk seeking bidders are more willing to participate at higher payment^{3}.

## Types of Auctions

There exist many different types of auctions. Base on the allocation rules and payment rules, we may have first-price auction (FPA), second-price auction (SPA), English ascending-bid auction, Dutch descending-bid auction, etc^{4}. Shoham and Leyton-Brown have provided a list of canonical auctions in their book^{3}.

### First-price Auction

There are two key relations:

- map from valuation $v_i$ to bid $b_i$, aka bidding function,
- map from bidding $b_i$ to the probability of winning $P(\mathrm{win})$.

To measure the expected payoff of a bidding price $b_i$ for bidder $\mathscr B_i$, we introduce the expected utility, $\bar U_i$, e.g.,

\begin{equation} \bar u_i = P(\mathrm{win}) (v_i - b_i) + P(\mathrm{lose}) 0 = P(\mathrm{win}) (v_i - b_i), \end{equation}

where $P(\mathrm{win})$ is the probability of winning and $P(\mathrm{lose})$ is the probability of losing. Given the probability of winning, valuation, and bid, one could usually calculate the expected utility $\bar U_i$.

There is no dominant strategies in first-price sealed auction. Everyone could set their bid lower than their valuation and win. That being said, the bid of first-price auctions do not necessarily approach one’s valuation. However, using the expected utility, it is proven that the strategy is to bid with $\frac{n-1}{n}v_i$ where $n$ is the number of bidders and $v_i$ is its valuation, given the condition that bidders are risk-neutral with valuations being a uniform distribution. (Theorem 11.1.3 in Shoham 2008)^{3}.

## References

F. Muñoz-García, “An Introduction to Auction Theory for Undergraduate Students,” no. 509, pp. 1–19, 2012. ↩︎

W. Vickrey, “Counterspeculation, Auctions, and Competitive Sealed Tenders,” J. Finance, vol. 16, no. 1, p. 8, 1961. ↩︎

Y. Shoham and K. Leyton-Brown, “Multiagent Systems: Algorithmic, Game-Theoretic, and logical foundations”, 2008. ↩︎ ↩︎ ↩︎

P. Klemperer, “Auction Theory: A Guide to the Literature.” . ↩︎

Lei Ma (2020). 'Auction Theory Basics', Intelligence, 11 April. Available at: https://intelligence.leima.is/economics/auction-theory/auction-theory-basics/.