Internet auctioneers such as eBay may be the instigators of a
               revolutionary leap forward in the efficiency of the price mechanism
 

               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.