Next Class: Design of Auction Format

1. Next Class: Design of Auction Format • Dutch auction (D) (e.g, www.landsend.com ) • First-price sealed-bid auction (F) (e.g., US Treasury bills, supply contracts; government procurement (10% GDP)) • Second-price sealed-bid (Vickrey) auction (S) (e.g., www.sandafayre.com; NZ’s communication spectrum rights) • English auction (E) (e.g., www.ebay.com ; www.yahoo.com )

2. Auction Principles I. Economic and Behavioral Foundations of Pricing II. Innovative Pricing Concepts and Tools III. Internet Pricing Models

3. Outline • Lessons from Auction Simulation Exercise • Optimal bidding and reserve price • Two important auction principles • Economics of Ebay’s Business Model • Revenue model design

4. Independent Private-value English Auction • Buyers’ valuations (WTPs) are independent of each other (e.g., antique & art, collectibles, Jewelry & Gemstones, etc.) (for own consumption) • In our simulation exercise, buyers’ WTPs for the airline ticket are independent draws from a uniform distribution ([0, 1000]) • An open English ascending bid auction • What is the optimal bidding strategy? • What is the optimal reserve price?

5. Optimal Bidding Strategy (one seller) • If there is no snipping (auction is closed only when no bids are submitted for a certain duration), the auction theory predicts that buyers should slowly increase their bids until the highest bid exceeds their WTPs • The open English auction mechanism induces truth revealing of WTPs (price points where bidders drop from the auction) • Revenue = Second highest WTP http://help.yahoo.com/help/us/auct/asell/asell-01.html Auto Extension: This option for sellers automatically extends the amount of time left to bid by five minutes if someone places a bid near the end of the auction.

6. Predicted Versus Actual Bids and Reserve Price

7. Prices at Each Round Price of 1st item Price of 2nd item 3rd highest WTP Round 1 Round 2 Round 3 Round 4 Round 5 Round 6

8. Expected Seller Revenue (one seller) • Let buyer WTPs (independently drawn from an uniform distribution) are denoted by WTP1, WTP2, …, WTPn-1,WTPn • Arrange them in an ascending order and denote ranked bids by WTP(1), WTP(2), …, WTP(n-1),WTP(n). That is, we have WTP(1) < WTP(2) < …< WTP(n-1) < WTP(n) • Expected Revenue:

9. Expected Revenue versus Number of Bidders

10. Optimal Reserve Price (one seller) (uniform distribution) • Optimal reserve price: • If the reserve price is smaller than the second highest WTP, reserve price has no revenue effect on the bidding process • If it is between the highest and the second highest WTPs, it will force the highest bidder to go beyond the second highest WTP (the point where the second highest bidder drops out).

11. Predicted Versus ActualBids and Reserve Price

12. Revelation Principle • Revelation Principle: All buyers (except the winner) end up revealing their WTPs for the item to the sellers. Put differently, sellers can “discover” distribution of buyers’ WTPs via the auction mechanism. This is not the case for other pricing mechanisms (e.g., seller posted price and priceline model) • Application: Use open English auction to discover the distribution of WTPs and then use seller posted price model to maximize share of surplus

13. Efficiency Principle • Efficiency Principle: The auction mechanism guarantees that the item always goes to the buyer with the highest WTP in a market. Again, this is not always the case for other pricing mechanisms • (inefficiency = 0% (predicted) versus (actual)) • Observation:Auction model is likely to dominate the other price models in terms of total social surplus generated.

14. Maximum Possible Surplus (MPS) WTP Buyer 1 40 Buyer 2 20 Buyer 3 15 Buyer 4 90 Buyer 5 60Buyer 6 50 Seller 1 c=0 Seller 2 c=0 MPS = 40 + 90 + 60 + 50 = 240

15. Disadvantages of Auctions • Can be stressful for some buyers, especially for end consumers (this can be however solved by proxy bidding). Thus, it is less likely to work for low purchase-involvement product categories • There are more losers than winners (and losers are less likely to revisit the website) • Strategic manipulation (e.g., shilling)

16. Earnings of individual groups

17. The Winning Team • The winning team is: • The prize is: + $60

18. Ebay’s business model Price Setting Party Seller & Buyer Buyer Seller Static Price Over Time ebay.com Dynamic http://www.ebay.com/

19. Ebay’s Original Revenue Model • M = Total number of items listed per year • Feei = Insertion fee of item i • Comi = Final value fee of item i • Ii= 1 if item i is sold; 0 otherwise M depends on number of people in the community Comi x Ii increases with price or seller surplus Revenue Levers

20. Ebay’s Original Revenue Model Biggest strength of the revenue model: Revenues increase linearly with M but costs do not increase M. (scalability property)

21. Ways to Enhance Ebay’s Revenue • Increase M • Increase size of community, • Enter new markets and product categories • Increase turnover (e.g., reduce bidding duration, encourage setting of buyout prices) • Increase Feei • Encourage more pictures and promotion of items • Increase Comi • Increase average number of bidders / auction (so as to increase seller surplus) • Encourage High-priced items (e.g., electronics, cars) • Increase Ii • Increase average number of bidders / auction so as to increase the probability that the highest bid > reserve price • Encourage a lower reserve price (e.g., the recent increase in insertion fee for reserve price auction)

22. EBay’s Revised Revenue Model • Fees to list an item • for regular auctions, fees is a function of starting price • for vehicles, a function of type of vehicles • for real estate, a function of types of properties and listing type • Picture Service Fees—first picture free, additional picture or bigger picture incurs fees • Listing upgrade fees: various options to promote items • Final value fees • for regular auction, charged when reserve met, at a function of the closing bid • For vehicles, charged when the first bid over the reserve price is placed (regardless of whether sale is finally made) • For real estate, a fixed fee for land/time share where there is successful high bid on the item and no fees for other type of real estates • Reservation Price Fees—charged only if item not sold, a function of reserve price

23. Ways to Enhance Customer Experience • Bidder Management • Smart search capability to narrow consideration set • Winner Management • Trust and safety initiatives • Loser Management: For every winner, there are (n-1) losers. Find ways to get them to bid again: • Follow-up emails on availability of related items • Seller Management • Loyalty programs for frequent sellers

24. Recipe for Continued Market Leadership • Liquidity, liquidity, liquidity • Keep Existing Customers Happy • Increase switching costs • Increase post-auction satisfaction • Acquire New Customers • New markets (e.g., Canada, UK, China, etc.) • New products (especially high-priced items) • Direct acquisition of customers / sites

25. Punchline • Open English Auction • Revelation Principle • Efficiency Principle • Ebay’s Business Model • Revenue increases with seller surplus • Liquidity promotes lock-in: Keep existing customers happy and acquire new customers • Diversification: New markets and new products (especially high-priced items)

26. Exercise • Visit google answers: http://answers.google.com/answers/ • Figure out its revenue model and levers? • Suggest 2 ways to improve the revenue model