When Are Auctions Appropriate?

We have discussed the advantages of auctions and how, when properly designed, auctions can help achieve diverse objectives. But it’s important to remember that auctions are just one out of an array of different mechanisms for vending and distributing goods. And just as there’s no one-size-fits-all format for all auction applications, auctions aren’t always the best or most appropriate allocation mechanism for all goods and all markets. (For example, there are list-price sales, where transactions are made at fixed, predetermined prices; “first come first serve” distribution, still used today in circumstances like “hypebeast” drops of limited-edition apparel; and lotteries, which are often held when the allocating party is less concerned with who receives the assets than that as many people participate as possible.)

This final article in our auctions series offers a few cautionary tales, where inappropriate application of auctions led to unintended negative consequences. We also review existing research to predict which applications in blockchain are likely to benefit from the use of auctions.

Online goods auctions: from omnipresence to obsolescence?

In the early days of Internet commerce, consumer auctions were hugely popular, as best exemplified by eBay, which was the third-ranked website by time spent by consumers in 2001. eBay’s growth since its founding in 1995 was fueled by a technological development in online auctions called “proxy bidding.” It significantly reduced the transaction costs associated with participating in auctions by allowing buyers to use simple computer algorithms to react to opponent bids, setting limit prices, bid-up increments and other automated responses without demanding manual buyer oversight until, perhaps, the final minutes of an auction.

But in the decades since then, online commerce has seen tremendous growth, which has been accompanied by a dramatic shift from auctions to posted prices for all but the most unique or novel goods. That’s true even on eBay itself, where the share of all listings that execute via auction fell from over 95% to slightly above 10% in ten years (Einav et al., 2013), primarily due to a change in buyer demand away from auctions in favor of the more convenient “Buy Now” option.

Auctions are still the primary mechanism for the online sale of used and idiosyncratic items. But trends in the commerce space toward less uncertainty about the value of items, greater retail competition, and greater demand for convenience all favor posted prices over auctions. In particular, a dramatic increase in access to price-comparison information has made the price discovery features of auctions redundant.

And sellers who have continued to use auctions for items that aren’t particularly unusual seem to be doing so for a different purpose: They’re using auctions to charge different consumers different prices, by selling similar items in a range of different reserve prices, quantities or types of bundles — a practice closer to the use of couponing and other promotional strategies by traditional retail markets. Rather than being used to discover true prices for goods, auctions held in this manner may be designed to obscure that pricing.

When being too effective is a problem

While the rise and fall of auctions on eBay is a saga of how auctions as a pricing mechanism become less necessary as marketplaces mature, there are also examples of how auctions can work exactly as planned and still generate unintended consequences. One example is event tickets — a category that has confounded economists and regulators for more than a century, due to the fact that popular tickets are commonly sold out quickly, and then resold on secondary markets for many times their face cost. This would seem to indicate that tickets are significantly underpriced, which reduces revenue to artists and distribution platforms, while giving ticket scalpers a disproportionate share of ticket market value.

Auctions seemed to be an obvious solution to the problem, and in 2003, that’s precisely what Ticketmaster, introducing the first dedicated auction market that allowed fans to bid on scarce tickets for hot events. Theoretically, the auction design would offer attractive efficiency and added revenue, and eliminate the third-party arbitrage opportunity exploited by scalpers. It also worked in practice (as well-designed auctions should) (Bhave and Budish, 2017): For events that adopted the auction format, price discovery substantially improved, artist revenues roughly doubled and potential resale profits for speculators on secondary markets almost disappeared.

But despite its initial success, Ticketmaster chose to kill its auctions platform. The decision could be attributed to a few reasons: New technologies allowed Ticketmaster to better restrict resales and more accurately estimate market-clearing prices. And Ticketmaster had also launched its own secondary-market platform, allowing it to better regulate and monetize ticket resales, making primary auction markets less necessary. But the biggest reason why Ticketmaster chose to kill the golden goose of ticket auctions was noneconomic: Using auctions to allocate certain kinds of goods incurs a “repugnance” cost (Roth, 2007), because people value fairness and affordable (if scarce) public opportunities to obtain a benefit more than the most efficient means of allocating that benefit. By using auctions to set the initial non-resale prices for concert tickets, the average cost of those tickets went up astronomically, beyond the ability of most buyers (who might otherwise camp out in front of ticket offices or rely on fast-finger clicking techniques to potentially get a chance at super-scarce ducats). The backlash from ordinary fans was enough to chill Ticketmaster’s interest in simply generating more money. The bottom line: When choosing the most appropriate way of allocating resources, a designer has to respect social perceptions as well as economic realities.

Applications to Blockchain

While cryptocurrencies and other fungible tokens are likely to use other pricing mechanisms, NFTs and other digital assets, however, have features that render them especially well-suited to auctions. In particular, because NFTs are often idiosyncratic and lack firm pricing precedents, auctions can prove vital to facilitating their price discovery, much like in physical art markets.

The only caveat is that NFT auctions are still subject to irrational price fluctuations caused by the “Keynesian beauty contest.” A beauty contest is an allegory introduced by John Maynard Keynes, in which he imagines a competition where every participant is asked to choose the six most attractive faces from a hundred photographs. Those who submit the most popular faces get a prize. Because of this incentive, participants don’t end up answering based on their personal opinion, but on what they think others believe is the average opinion, or even more complicated attempts to “game” the system. At the same time, this isn’t an issue with auctions — it’s a fundamental problem for any circumstance where assets are being allocated in the absence of intrinsic values or firm precedents. No other pricing mechanism provides a better solution than auctions.

Perhaps the best-known application of auctions in blockchain is their use in how the Ethereum gas fees are determined. As we’ve noted before, on the Ethereum network, users who need to process transactions submit bids to a first-price auction. The winners pay what they bid and get their transactions confirmed immediately; if not, they pay nothing and have to wait for the next block. The gas fee auctions balance supply and demand, and guarantee those who value confirmation speed the most get their transactions processed first. While these auctions are efficient in allocation block spaces, they also lead to wild fluctuations in gas fees when the network is under pressure (“congested”), which exacerbates the network’s existing scalability problem and tends to crowd out all but the most lucrative uses of the Ethereum blockchain.

In order to address this problem, the highly anticipated EIP-1559 upgrade proposes a major change to Ethereum’s transaction fee mechanism, which replaces the auction with a varying base fee and a supplementary transaction “tip.” We have yet to find out if this upgrade will achieve what it sets out to do, but one thing is for sure: there is no free lunch in market design. When auctions are not getting the job done, we need to consider alternative market mechanisms, and in the process accept some trade-offs for the prioritized objectives.

Source: https://medium.com/community-economics-by-forte/when-are-auctions-appropriate-a0276b77b587?source=rss——-8—————–cryptocurrency