The heyday of the auction

AS AN example of all that is frothy, faddish and foolhardy about investment in Internet shares, you might be tempted to choose eBay. Despite its much-hyped initial public offering, its towering share price and its multi-billion dollar market capitalisation, this is a company that made its name by helping people to buy and sell, for example, beanie babies, second-hand surf-boards and other stuff that would otherwise end up as junk. But while eBay's share price may be crazy, it would be wrong to dismiss the company as just another symptom of a mania. There is method in this madness. Online auctions may be one of the most valuable innovations wrought by the Internet.

Economists have long recognised the virtues of auctions. In 1880, Léon Walras, a French economist, described the entire price mechanism as an auctioneer, attaching a body to Adam Smith's “invisible hand”. The “Walrasian auctioneer” would call out a price, see how many buyers and sellers there were and, if these did not balance, adjust the price until demand equalled supply.

But in practice, for most of human history, auctions have not played a starring role in the price-setting process. Mostly they have been limited to agricultural and other commodity markets, fine art and antiques, and— of increasing importance in recent decades—some types of financial securities.

Two other forms of price-setting have been dominant: one-to-one negotiation (haggling); and the non-negotiable menu of prices offered by seller to buyer. These two approaches are not bad: the price mechanism based on them obviously does a much better job of allocating scarce resources than do centrally planned systems that eschew prices altogether.

But each method has important flaws. When there is a menu, the most that people will reveal about their demand for a given product is whether or not they are willing to buy at the listed price. So unless the seller has, from other sources, an intimate knowledge of supply and demand conditions, the price he sets may have highly inefficient consequences. Moreover, menu prices can be “sticky”—slow to adjust to changes in the balance of supply and demand.

One-to-one haggling has the advantages of interaction and dialogue, which improve the chances of reaching a mutually beneficial outcome. But it also carries a big risk: that the seller or buyer may not be negotiating with the best person (ie, the one willing to pay the most, or sell for least).

Auctions can overcome these shortcomings by soliciting a wide range of bids from many people. And the Internet, thanks to its cheap interconnection of millions of people, makes well-functioning auctions far easier. They are now possible for many goods and services that used to rely on haggling or menus. And even in markets where auctions have long been used to set prices, the Internet can make them much more sophisticated than ever before.

So far, the leading online auctions are fairly simple, but highly popular, affairs. Already eBay boasts 2.4m sale-items in 1,627 categories. One reason for its success, and for that of the auctions more recently offered by uBid, Amazon, Yahoo! and others, is that they are entertaining. America is now full of auction addicts crowing about their latest success or bemoaning a near miss. Yet the phenomenon has also introduced useful economic efficiencies, creating big new markets by bringing together a large number of participants—the “eBay community” alone boasts 3.8m members.

Steve Kaplan, an economist at the University of Chicago, points out that online auctions have a big economic advantage over traditional online menu-priced sites, such as that pioneered by Amazon. Such sites cut out the cost of going to the shops, and make it cheaper to compare prices with other retailers. But Amazon's customers are no better off if it attracts more users. Whereas the more buyers and sellers turn up on eBay, the better their chances of getting a good deal, as the auction becomes deeper and more liquid.

On eBay, auctions are transparent: all bids and bidders are published. This generates valuable information for buyers and sellers, though it has one negative side-effect: it increases the risk of collusion (often a factor in traditional auctions) because participants can secretly e-mail each other, and negotiate side-deals.

But eBay has found elegant solutions to some potential hazards of auctioning online, notably fraud. Regular sellers can establish a reputation for reliable delivery and quality, through a rating and comment system based on the experience of customers. Indeed, beefing up such quality-control functions may be behind eBay's recent purchase of one traditional auction house, Butterfield's, and Amazon's link-up with another, Sotheby's.

Needless to say, fixed prices are not going to disappear. Taking part in online auctions is time-consuming (and nerve-wracking). Economic theory suggests they are most useful in particular circumstances: when there is uncertainty about what is the right price. This could be for one of two reasons. Either the value of a product is a matter of private taste and opinion—such as a Van Gogh painting or a rare Spice Girls doll. Or the value is likely to be similar for everyone, but it is not obvious to the seller what it is—such as a rail-operating franchise or a radio-bandwidth licence.

Hammer and tongs

The battle for online-auction business is heating up. FairMarket is hosting auctions for many e-retailing sites, including Lycos, ZD Net, CompUSA, and Cyberian Outpost. And then there is Priceline, a quasi-auction, which sells airline tickets (and hotel rooms, mortgages and cars, with more to come) by inviting customers to submit bids for travel on a particular day. It has the usual stellar share price. However, Paul Milgrom, an economist at Stanford, is sceptical about its long-term prospects, because it lacks some crucial ingredients. In a genuine auction, offers are compared and the best one is taken. With Priceline, you name a price once, and you either get the item or not: the bidder has limited information about what is available, and none about how many other would-be buyers there are, and so has little chance to get a good deal.

Other sorts of auction may have greater promise. W.R. Hambrecht, an online investment bank, is using auctions to sell initial public offerings of shares. Investors submit secret bids; the price is set at the highest level at which all the available shares can be sold; and they are allocated at that price to everybody who bid that amount or more.

According to Peter Cramton, an economist at the University of Maryland, many IPOs display classic signs that shares are being sold too cheaply, and to the wrong people (ie, not to those who value them most highly). Typically, there is a sharp rise in price on the first day's trading, and a huge volume of shares changes hands.

These are exactly the sorts of problems that can be solved by an auction, but Mr Cramton suggests that W.R. Hambrecht's method may be unduly timid. A normal ascending price auction might be better. A bigger problem may be that big investment banks like the old system, which lets them give IPO shares to favoured clients, who can sell them at once for a juicy profit. Firms also like the splash of publicity they get when shares soar after an IPO; W.R. Hambrecht's recent flotation of Salon.com, a “website for intellectuals”, was widely thought disappointing because the shares did not soar to an instant premium. In fact, this showed a well-functioning auction: shares had gone to those willing to pay most for them.

Business-to-business auctions show considerable promise, and are expected soon to make up most of the volume of the online market. Because transactions between businesses tend to be relatively infrequent, the seller may be uncertain about the right price. Auctions can tell him. One online auctioneer, Freemarkets, held auctions worth over $1 billion in 1998 alone, for materials and components ranging from plastic moulded parts to energy.

Business-to-business auctions demand greater care than consumer auctions. Yoav Shoham of TradingDynamics, a firm that is developing a wide range of sophisticated online auctions for businesses, points out that they usually involve larger amounts of money, that firms are not seeking entertainment, and they do not want to jeopardise any long-term strategic relationships.

“Combinatorial auctions” may be the next big thing. These allow businesses to bid for many things at the same time, taking into account the fact that the different goods may be complementary (it is worth more to have both than just one) or substitutes (if you get one, you do not want the other). Charles Plott, an economist whose company, Computerised Market Systems, is developing a range of complex auctions, is currently testing an auction for radio licences: the more you have of these the better. It tells the bidder in seconds if his bid would succeed, and, if not, what to do to win.

Also growing fast are highly specialised business exchanges, such as e-STEEL, a steel exchange. These are, in effect, two-way auctions bringing together many buyers and sellers. This resembles a financial exchange where buyers and sellers submit the prices they are willing to pay (the bid) or sell at (the asking price); when matches are found, a trade takes place.

A year ago, there were around ten online business exchanges, offering products such as computer chips and road-freight capacity. Now there are 300-500; and the total is forecast to rise quickly to several thousand. Most of them began as bulletin boards that posted fixed prices, but they are rapidly switching to dynamic pricing by auction.

The combination of Internet and auctions also makes possible the creation of entirely new “info-markets”. Hewlett-Packard, for instance, is testing (with Mr Plott) a two-way auction-market for securities whose value depends on how many computers (and some other products) the company sells during a particular period. Only HP personnel who are likely to have relevant inside information can participate. Only the security that represents the actual sales outturn pays a substantial dividend; the rest pay nothing. People can trade as often as they like. Price is set by supply and demand.

The attraction to HP—and potentially many more companies—is that continuous auction-markets of this sort offer a much better way of gleaning valuable information. That is because traders have a strong incentive get their prediction right (rather than say what they think their managers want to hear). So far, in each of 19 test runs, HP has found that the system is better at predicting actual sales than in-house forecasts.

Beware the winner's curse

There are dangers in the spread of auctions. According to Gerald Faulhaber of the Wharton School, people who use Internet auctions are likely to be different from those who do not. Online-auction fans are probably quite price-sensitive and so get a good deal; the others, maybe less well-informed, are more at risk of being exploited.

Online auctions, like offline ones, will always be at risk of collusion and fraud. And there is the “winner's curse”—the tendency for a bidder to be successful only because he has paid too much. However, this occurs more often when the auction is by single, sealed bids; straightforward ascending-price auctions, which are fairly easy to offer on the Internet, carry less risk of this because participants can see the rate at which other bidders are dropping out.

Although prices are likely to become more efficient, that does not mean they will all get lower. According to Bill Sahlman of Harvard Business School, the price of second-hand items is likely to rise. This is because online auctions will create a much deeper market. But prices of new things are likely to fall, not least because of greater competition from the second-hand market.

Some sellers are likely to try hard to slow the progress of auctions that increase price competition, as they do not want their margins squeezed. But once competitors start to use dynamic-auction pricing, they may be forced to follow suit. And the trend is clear: towards happier customers and more competitively priced markets. Thanks to Internet auctions, some big inefficiencies in the price mechanism will soon be going, going, gone.