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
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
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
On eBay, auctions are transparent: all bids and bidders are published.
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,
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
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
“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
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
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.