Buyer’s behavior
In online auctions as opposed to traditional auctions

Table of contents

1. Introduction 3

2. Online auctions as opposed to traditional auctions 3 3.1. Advantages online auctions 3 3.2. Risks of auctions 4

3. Buyers decision-making process in auctions 4

4. Type of auction 5 5.3. English auction 5

5. Economic theories 6 6.4. Rational behavior 6 6.5. Effects of irrational behavior 7 6. Conclusion 7 7. References 8

1. Introduction

While the Internet has become an essential resource in the global economy, it has not only changed the way consumers think, behave, and make decisions, it has also changed businesses. Since the opportunity of reaching out to a mass-market was created as a result of the Internet and its easy accessibility, businesses are scrambling to take advantage of changes in their markets. An example of one of those businesses is an auction. As a result of the development of sophisticated software that enables businesses to buy and sell on the Internet under secure conditions, the e-business model of auctions, called online auction, has emerged. Online auctions adapt the traditional auctions to the instantaneous advantage of the Internet to reach new markets that were previously cost-prohibitive by reducing transaction costs. Advantages such as the size and scope of the audience are enabling Internet auctions to play a major role in the emerging global economy (Sashi & O’Leary, 2002).

The aim of this paper is to look deeply at how the buyers behavior, and their decision making process, has changed in online auctions as opposed to traditional auctions. The research has been conducted from the perspective of the buyer. Firstly, the paper will compare online auctions and traditional auctions. Secondly, it will look in depth at the buyer’s decision making in auctions. Finally, the paper examines the corresponding economic theories, such as the cost and benefit analysis, Nash equilibrium, dominant strategy, asymmetric information, and the winner’s curse.

2. Online auctions as opposed to traditional auctions

Originally, auctions were used as a method to trade goods that do not have a fixed price, such as antiques. Since the spread of the Internet, during the last decade, the growth of trading on the Internet has quickened. As a result, auction businesses also expanded rapidly on the Internet and became a large system to trade any good. 2.1 Advantages online auctions
Online auctions have several differentiating characteristics that explain their growing popularity. First, online auctions have, as opposed to many traditional auctions, no geographical limitation, which allows the business to reach a large number of potential customers without distance limitations. Second, in terms of duration, Internet auctions can give both sellers and buyers more flexibility because it can last for several days, which allows asynchronous bidding to occur. Moreover, the websites of online auction businesses can operate at lower cost than the traditional auction houses and can thus charge lower commission fees and attract more sellers and buyers.

2.2 Risks of auctions
There are risk effects that might accrue to buyers resulting from the existence of seller reserves. Besides those risks, there are also numerous high risks associated with online auctions. Hofacker (1999) enumerates at least five risks associated with buying online: (1) Time risk, the risk that the buyer may waste valuable time engaging in product search; (2) Vendor risk, the risk that the seller may not be trustworthy and defraud the buyer; (3) Security risk, the risk of loss of valuable information, such as credit card numbers; (4) Brand risk, the risk that the specific product may have problems, and (5) Privacy risk, the risk that personal information about the buyer may be passed along to other vendors.
Those five risks are particularly high for online auctions. However, online auctions have a lower risk in price information. Which Massad and Tucker (2000) argue that reduces purchase uncertainty, because the perceived risk in a buyer’s behavior context is largely moderated by the buyer's ability to search out information online. Due to the reduced price information risk, bidders with more information are likely to be willing to pay more than bidders with less information (Cox, 1963).

3. Buyers decision making process in auctions

In general, the buyers decision making process, meaning the process individuals go through to select and purchase goods to satisfy their needs and desires, are very similar in online and traditional auctions. The first decision a buyer needs to make is whether to enter an auction. Decisions to enter auctions are likely to depend on the purpose and context of the visit, and whether it involves impulse or planned bidding. Another key point is that in both scenarios, buyers might often bid on items that they would not have considered purchasing in an ordinary retail environment. The middle phase of auctions spans from the time that a bidder places an initial bid until just before the end of the auction. During this phase, buyers in both online and in traditional auctions need to decide whether, when, and how much to raise their bid, or whether to drop out. The conclusion of an auction thus is where the ‘winner’ and ‘losers’ are determined. This is where each of the participants must decide what kind of resources they are willing to invest to win. Thus, the main differentiating characteristic of the end of an auction is that, unlike earlier phases, decisions at the end are clearly consequential and often irreversible.

Although, as mentioned earlier, the buyer’s decision making in general is quite similar, buyers have more options in online auctions. For example when it comes to choosing an auction to participate in and more options when it comes to the auctioned items themselves.

4. Type of auctions

According to McAfee and McMillan (1987), an auction is a market institution with an explicit set of rules determining resource allocation and prices on the basis of bids from the market participants. The rules allow us to classify auction types. The most popular online auctions are ascending English auctions, descending Dutch auctions, first-price auctions, Vickrey auctions, or sometimes even a combination of multiple auctions, taking elements of one and forging them with another.

4.1 English auction
In this paper only English auction will be discussed. English auction is considered a dynamic auction: participants bid sequentially over time and, potentially, learn something about their opponents’ bids during the course of the auction (Ausubel, 2003). In an English auction the price ascends: bidders dynamically submit successively higher bids for the item. The final bidder wins the item and pays the amount of his final bid (Ausubel, 2003).

Value assessments in English auctions are influenced by the specifications of the item being auctioned. Of particular interest are: the item's reserve price, the minimum price at which the seller is willing to sell the item (Häubl & Popkowski Leszczyc, 2001), the number of bids submitted up to that point, and in some cases, assuming some bidders are known for their domain expertise, the identity of bidders (Ockenfels & Roth, 2001).

An advantage to English auctions is that a bidder gains information. He can observe not only that other bidders drop out, but also the highest bids at past moments. That tells a bidder a lot about the valuations of others and allows a bidder to increase his valuation during the auction. Given the current price in the auction, each bidder needs only to decide whether or not to drop out at that instant. The fact that the current price can be observed means that bidders should stay in until the price is the same as their estimate of the value, conditional on all available information. Hence, the outcome of the English auction is for each bidder to set her strategy equal to her true valuation.

5. Economic theories

Studying microeconomics, this paper can assume that the bidders are rational – that they have well-defined goals and try to achieve them as best they can, or irrational. When analyzing rational behavior, economic principles, such as the Cost-Benefit Principle, Nash equilibrium, and the dominant strategy, occur. If bidders are irrational, due to information problems, asymmetric information and the winner’s curse are introduced.

5.1 Rational behavior
Assuming that bidders are rational, they apply the Cost-Benefit Principle:

A bidder only takes an action if, and only if, the extra benefit of taking the action is at least as great as the extra cost. The benefit of taking any action minus the cost of taking the action is called the economic surplus form that action. Hence the Cost-Benefit Principle suggests that we take only those actions that create additional economic surplus. (McDowell & Thom et al., 2009, p. 21)

An auction with rational bidders leads to Nash equilibrium. A game is said to be in equilibrium if each bidder’s strategy is the best he or she can choose given the other bidders’ chosen strategies. Furthermore, each bidder has a personal value for the item that is being auctioned. It is a dominant strategy to stay in the bidding until the standing bid reaches the desired value. The penultimate person will withdraw from the auction once her value is reached, thus the person with the highest value will win at a price equal to the second-highest value.

5.2 Effect of information problems
One of the most common information problems occurs when the participants in a potential exchange are not equally well informed about the product or service that is offered for sale. Economists use the term asymmetric information to describe situations about the characteristics of products or services. In these situations, sellers are typically much better informed than buyers. This represents a bigger problem for bidders, especially in traditional auctions. Another problem that may occur in English auctions with incomplete information is the winner’s curse. The winner may be cursed or overpay when the winning bid exceeds the value of the auctioned item or when the value of the item is less than the bidder anticipated. Before the bidding, each bidder independently estimates the value of the item. But whenever a bidder’s valuation depends on the opposing bidders’ information in an increasing way, the possibility of a winner’s curse is introduced. However, this problem occurs more often in traditional auctions than in online auctions. Because in online auctions bidders have access to more information.

6. Conclusion

Online auctions have several differentiating characteristics that explain their growing popularity. They have advantages, such as lower cost, flexibility in terms of duration, and no geographical limitation. There are risk effects that might accrue to buyers resulting from the existence of seller reserves. Besides those risks, there are also numerous high risks associated with online auctions. Time risk, vendor risk, security risk, brand risk, and privacy risk, are risks that are particularly high for online auctions. However, online auctions have a lower risk in price information. Which reduces purchase uncertainty, because the perceived risk in a buyer’s behavior context is largely moderated by the buyer's ability to search out information online (Massad & Tucker, 2000). Due to the reduced price information risk, bidders with more information are likely to be willing to pay more than bidders with less information (Cox, 1963). Furthermore, irrational behavior, due to information problems, which can lead to asymmetric information and winner’s curse, is more likely to occur in traditional auction than in online auction. Which cohesively disables Nash equilibrium to arise, and avoids the Cost-Benefit principle.

To conclude, bidders have more options when it comes to online auction than in traditional auction. Moreover, irrational behavior takes place more frequently in traditional auction due to all the disadvantages.

References

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