What is a Second-Price Auction and Why We Like It
The U.S. has witnessed a crazy housing market has in the past year with demand far outstriping supply. Buyers are involved in bidding wars by adding an escalation clause to the offer, saying that if there are competing offers, the buyer would like to bid $10k, for example, higher than the competing offer until some maximum value. If the competing offer also has an escalation clause, which is often the case in the past year, the seller will communicate with all potential buyers until no one bids higher.
This is exactly how first-price auction works. Obviously, people don’t enjoy it for the word “war” being used. A second-price auction achieves the same goal, without a “war”. It is simple, and efficient. A bidding war happens because buyers do not want to pay the maximum amount in their mind for the house. They want to pay only a little bit higher than the others’ bids. A second-price auction does exactly that, without a “war”.
Let’s say Alex’s maximum amount for a house is $100k, and Bill’s maximum amount is $90k. In a second-price auction, Alex bids $100k and Bill bids $90k. And Alex pays $90k for the house. This is what happens in theory. The reality is slightly different.
Before going to the reality, I would answer an immediate question first: why does Alex and Bill bid their true maximum amount? It has been proven that bidding the true maximum price is the optimal strategy under second-price auctions. It is actually not very hard to prove that bidding a different price never helps but sometimes hurts by listing possible situations.
Now coming to the reality. Under the exact second-price auction mechanism, the seller can get $90k even if the seller secretly sells the house to Bill. Therefore, Alex can pay slightly higher than $90k so that the seller is better off by selling the house to Alex. Now, we arrive at the outcome of first-price auction, but without a bidding war!
At last, I would like to mention the Nobel prize winning Vickrey-Clarke-Groves (VCG) mechanism. It generalizes second-price auction for the case of multiple items (and multiple buyers of course). However, the VCG mechanism is much more complicated. I would like to write about VCG mechanism if three or more people are interested. So comment below!
