Different aspects of online auctions, eBay.

For assessor only | | 1. Content | | 2. Language structure | | 3. Language accuracy | | 4. Language: format & citing/referencing | | Overall: | | Advisory grade | | Assessor’s initials | |

Maastricht UniversitySchool of Business & Economics | Place & Date: | Maastricht, 10-12-2012. | Name, initials: | Elemans, DP | ID number: | I6049135 | Study | International Business | Course Code: | EBC1009 | Group number | 36 | Tutor name: | Nikita Krugljakov | Writing tutor name: | Gaye van Denderen | Writing Assignment | Main Paper (Task 10) |
Your UM email address: d.elemans@studentmaastrichtuniversity.nl

Table of contents:

1. Introduction 2. Advantages and disadvantages of online auction
2.1 Advantages
2.2 Disadvantages 3. Different types of auctions
3.1 English auction
3.2 Dutch auction
3.3 First-price sealed bid auction
3.4 Second-price sealed bid auction 4. Different methods of bidding 5. Winner’s curve. 6. Example of bidding, using game theory. 7. Conclusion 8. Reference list 9. List of figures and tables

1. Introduction

The internet itself started in the sixties in the United States. It has had massive growths and has given the population some very useful tools. The most current development is internet auction, also called online auction. Online auction is a service in which auction users or participants sell or bid for products or services via the internet. Sellers put products on the site and following this, buyers can place an offer that they are willing to pay for it. The sellers can then decide to accept this offer or wait for a higher offer to come. eBay is one of the most well known online auctions and therefore the main goal of this paper will be to describe the different aspects of an auction and see how auctions work in real-life situations, all this related to eBay.
Firstly, the advantages and disadvantages of online auction will be discussed, relating to eBay. Then the different types of auctions will be explained, giving the that is at work on eBay. Furthermore the methods of bidding will be discussed which will be followed by a real-life example of a bid in an auction, using game theory. Fifthly a review of the literature that is used will be given and finally a conclusion will be stated.

2. Advantages and disadvantages of online auction

2.1 Advantages
There are quite some advantages to the online auction. First of all the huge variety of the online auction, because there are so many sellers there are an enormous amount of products, that you will not find in one store. According to Engelberg and Williams (2006) there were traded goods and services worth more than $44.3 billion on eBay in 2005. Furthermore, the online auction has no limitations, geographically or time wise. You can buy something from somebody in China, while you live in Europe, because the seller will just sent it to you. Furthermore you have no opening hours limitations, because the store is online 24/7.

2.2 Disadvantages
On the contrary you also have disadvantages like fraud, this can happen to the seller but also to the buyer. From the sellers’ perspective, fraud can only occur in the case of money. What could happen is that the buyer sends the money from a hacked account or the buyer states that it did not receive the item. eBay has PayPal as a payment system, this is a system which has various protection programs, one being the Seller Protection, which protects the seller from the problems stated above (paypall.com)
The buyer has the same issues according to the payment. The buyer has to trust the seller to send the product, once the buyer sent the money. Moreover the product could be sent damaged or not as the seller told it to be, and then the buyer has already paid the money and most of the time will not get it back. Again, PayPal has a protection system for the buyers, Purchase Protection, which makes sure that if you do not receive the product or it is different as you expected, your money will be reimbursed (paypall.com).
Another case of fraud for the buyer is asymmetric information. Because the buyer cannot see the product, it does not know whether the product is actually the same as the seller displays it. This can lead the buyer into a situation in which it buys a product and finds out later that it is not as expected. To prevent this eBay, and other online auctions, have funded the online reputation system: this is the system that keeps track of the reputation of the sellers by using the feedback of the buyers (Lin, Li, Janamanchi, Huang, 2004). It rates the sellers, by giving the buyers the opportunity of giving them a score of 1 (positive), 0 (neutral) and -1 (negative), on eBay this is called the Feedback Forum. In this way other buyers can see whether the seller is a reliable one.

3. Different types of auctions

You have several types of auctions, namely the English, Dutch, first-price sealed bid and the second-price sealed bid auction. Moreover, auctions can have a limited time for the buyers to submit their bids, or there can be a reservation price of the seller, which means that the seller will not take a lower bid than that price.

3.1 English auction
This is a type of auction, where the price is raised until one bidder remains with the highest bid. In this type of auction, all the bidders know the current highest bid. It is called an open-ascending auction for this reason (McAfee & McMillian, 1987).

3.2 Dutch auction
This is also an open-ascending auction, but that is also the only similarity with the English auction. Namely on the Dutch auction, the auctioneer sets a clock price, which is a high price, and then lowers it until one bidder accepts the price (McAfee & McMillian, 1987).

3.3 First-price sealed bid auction
This is a type of auction, where bidders all make one sealed bid, and the highest bid wins the auction. The main difference with the English auction is that the bidders do not know what the highest bid is or what the other bidders are bidding (McAfee & McMillian, 1987)..

3.4 Second-price sealed bid auction
Also called the Vickrey auction, this works the same as the first-priced sealed bid auction, the difference being, that the person who has bid the highest bid, pays the second highest bid (McAfee & McMillian, 1987). As Engelberg and Williams (2006, p.2) state, ‘’eBay runs a second-price proxy auction with bid increments and time priority’’. This will be further explained in the next paragraph.

4. Different methods of bidding

There are different ways of making a bid, the most known being the auction sniping and the proxy-bidding.
Auction sniping is a way of bidding, where you place the highest bid on the final moment of a timed auction, which leads the other bidders no time to make a higher bid. This sort of bidding is often done in eBay according to Bajari and Hortaҫsu (2000, p.13) who state that ‘’the median winning bid arrives after 98.3% of the auction time has elapsed (within the last 73 minutes of a 3 day auction), and 25% of the winning bids arrived after 99.8% of the auction time elapsed (the last 8 minutes of a 3 day auction)’’. As you look at this from a smaller time frame, e.g. 1 day 25 % of the bids are set in the last 2 minutes and 40 seconds. This shows that auction sniping is at stake at a very high level on eBay.
As was noticed before eBay uses a proxy bidding system which means, according to Wurman, Zhong and Cai (2004, p.1 & p.2) that ‘’proxy bidding is the process in which the bidder expresses a bid – typically greater than strictly necessary to be accepted by the auction – to an agent, that then bids incrementally on behalf of the bidder until it either wins or exhausts the authority granted it’’. Bid increments are the minimum amount of money a bidder needs to higher his bid with. As you can see now, eBay uses a Vickrey auction, because you pay your second highest bid, not your maximum bid, but the ‘highest’ bid that was made by you, plus the increment.
The maximum bid of a bidder is the reservation price of the bidder, the maximum amount a person is willing to pay for the product. The reservation price is set according to the cost-benefit principle. Whatever the buyer things the product is worth is its benefit, and what the buyer is willing to pay for it is the cost. Set in this way it seems as an easy job to set your reservation price, however you do not know the benefit of the item. As was discussed before, there can be asymmetric information what leads to a higher (or lower) estimate of the value of the product. If there is made a higher estimate of the product this leads to the winner’s curve.

5. Winner’s curve

In an auction there are most of the time multiple bidders. All of these bidders have different estimates of the value of the product and will therefore set reservation prices higher or lower than the real value of the product. If a bidder has a higher estimate then the true value of the product, it will place a higher bid than bidders who have a low estimate of the product in the auction. The bidder with the highest bid wins and this will be the bidder with a high, or even the highest estimate of the product. This winner is said to be cursed in one of those ways: 1. The winning bid is higher than the actual value of the product and this leads to the winner making a loss. 2. The value of the product is lower than the winner estimated, so the winner will be disappointed. In this case the winner can still make a profit, if the value is higher than their bid, but it will feel like they made a loss.

6. Example of bidding, using game theory

As McDowell, Thom, Pastine, Frank and Bernanke (2012, p.261) note, ‘’there are three elements in a game, the players, the list of possible actions for each player and the payoffs the player receive for each combination of strategies’’. A game here can be called a bidding, the example being a bid over an antique chair. The players are the buyers, in this example there are 2 buyers. Furthermore the list of possible actions for each player and the payoffs they receive, is raising their bid and either getting the chair, or not getting it.
The chair is worth €50, but because it is antique they do not know whether it is worth €50 or more or less. There are two people who are willing to buy the chair, each having a different reservation price, namely for buyer 1: €50 and for player 2: €45. They start the bidding on €5, with a bid increment of €5. You can predict the outcome of this game by using the theory of games: a model on the way that you can predict the outcomes of the players. The outcomes, also payoffs, are dependent on the move of the other player. You can predict outcomes, in this case, by using a decision tree, because in a bidding people do not make decisions simultaneously but sequentially. Sometimes there is a Nash equilibrium; ‘’any combination of strategies in which each player’s strategy is his or her best choice, given the other players’ strategies’’ (McDowell et al., 2021, p.262).The decision tree, shown below will show the game at the point that the player 1 has the option to bid €45, which is the reservation price of player 2, and the possible reactions of player 2.

In this decision tree you can see that player 1 has the option to bid €45 or not, but because player 1’s reservation price is €55, it is highly likely that he will bid €45. Player 2 now has to think about whether he will raise his reservation price and bid €50, or to stop bidding. The Nash equilibrium that you can find out of this decision tree is not likely to be strategy 3 or 4 because player 1’s reservation price is €50 so he will bid €45. The Nash equilibrium will probably be strategy 2. This is because the reservation price of player 2 is lower than the necessary bid of €50. However, this is not the outcome that you will get 100 % of the time. This is because player 2 can decide to raise his reservation price. However, another possibility that could happen that for some reason player 1 does not bid 45, maybe because he lost his interest. In that case player 2 should also not bid 45, because the last bid would have been 40 and that would be from player 2. Therefore the most likely Nash equilibrium = (bid 45, (if bid 45 = do not bid 50, if do not bid 45 = do not bid 45).

7. Conclusion
The advantages of online auctions as eBay are that there is a lot of variety of the products and that there are no limitations. The disadvantages that occur are fraud and asymmetric information, but eBay overcame that with the PayPal security system and the Feedback Forum. There are different types of auctions, the English, Dutch, first-price sealed bid and the Vickrey auction. eBay uses the Vickrey auction, with a proxy bidding system. This proxy bidding was one of the different methods of bidding, and the other one that was mentioned was auction sniping. Another thing that can occur during a bidding was the winners curve, and that causes the winner of the bid to be disappointed most of the time. The last thing that was discussed was a bidding itself, where we found a Nash Equilibrium.

8. Reference list
Wurman, P., Zhong, J. & Cai, G. (2004). Computing Price Trajectories in Combinatorial Auctions with Proxy Bidding. Electronic Commerce Research and Applications, 3(4), 329-340.
McAfee, R. & McMillan J. (1987). Auctions and Bidding. Journal of Economic Literature, 25(2), 699-738.
Bajari, P., Hortacsu, A. (2000). Winner’s Curse, Reserve Prices and Endogenous Entry: Empirical Insights from eBay auctions.
Thaler R. (1988). Anomalies: The winner’s curse. The journal of economic perspectives, 2(1), 191-202.
Engelberg, J. & Williams J. (2006). eBay’s proxy bidding: a license to shill.
Lin, Z., Li, D., Janamanchi, B. & Huang W. (2004). Reputation Distribution and Consumer-to-Consumer Online Auction Market Structure: An Exploratory Study.
McDowell, M., Thom, R., Pastine, I., Frank, R. & Bernanke, B. (2006). The Principles of
Economics. (3th ed.) New York: McGraw-Hill. www.ebay.com www.paypal.com http://www.investopedia.com/terms/a/asymmetricinformation.asp#axzz2EebstGI3 9. List of figures and tables