April 15, 2006

1

Teck-Hua Ho

Auction Principles

I. Economic and Behavioral Foundations of Pricing

II. Innovative Pricing Concepts and Tools

III. Internet Pricing Models

April 15, 2006

2

Teck-Hua Ho

OutlineOutline

Lessons from Auction Simulation ExerciseOptimal bidding and reserve price

Two important auction principles

Economics of Ebay’s Business ModelRevenue model design

April 15, 2006

3

Teck-Hua Ho

Independent Private-value Independent Private-value English AuctionEnglish Auction

Buyers’ valuations (WTPs) are independent of each other (e.g., antique & art, collectibles, Jewelry & Gemstones, etc.) (for own consumption)

In our simulation exercise, buyers’ WTPs for the airline ticket are independent draws from a uniform distribution ([0, 1000])

An open English ascending bid auction

What is the optimal bidding strategy?

What is the optimal reserve price?

April 15, 2006

4

Teck-Hua Ho

Optimal Bidding Strategy (one Optimal Bidding Strategy (one seller)seller) If there is no snipping (auction is closed only when no

bids are submitted for a certain duration), the auction theory predicts that buyers should slowly increase their bids until the highest bid exceeds their WTPs

The open English auction mechanism induces truth revealing of WTPs (price points where bidders drop from the auction)

Revenue = Second highest WTP

April 15, 2006

5

Teck-Hua Ho

Predicted Versus Actual Bids Predicted Versus Actual Bids and Reserve Priceand Reserve Price

PredictedPredicted

By AuctionBy Auction

TheoryTheory

Actual Actual

BehaviorsBehaviors

Bid as % of WTPBid as % of WTP

(except winners)(except winners) 99% ?

Reserve PriceReserve Price ? ?

April 15, 2006

6

Teck-Hua Ho

Prices at Each RoundPrices at Each Round

Round 5

Round 4

Round 3

610.0Round 2

732.0Round 1

3rd highest WTP

Price of 2nd item

Price of 1st item

Round 6

580.0

631.0

671.0

790.0

839.0 350.0

850.0 850.0

662.0 642.0

798.0 760.0

630.0 613.0

674.0 650.0

April 15, 2006

7

Teck-Hua Ho

Predicted Versus ActualPredicted Versus Actual Bids Bids and Reserve Priceand Reserve Price

PredictedPredicted

By AuctionBy Auction

TheoryTheory

Actual Actual

BehaviorsBehaviors

Bid as % of WTPBid as % of WTP

(except winners)(except winners) 99% 95.5%

Reserve PriceReserve Price 500

April 15, 2006

8

Teck-Hua Ho

Expected Seller Revenue (one Expected Seller Revenue (one seller)seller)Let buyer WTPs (independently drawn from an uniform

distribution) are denoted by WTP1, WTP2, …, WTPn-1,

WTPn

Arrange them in an ascending order and denote ranked bids by WTP(1), WTP(2), …, WTP(n-1), WTP(n). That is, we have WTP(1) < WTP(2) < …< WTP(n-1) < WTP(n)

Expected Revenue: WTP

n

nWTPE n

1

1)( )1(

April 15, 2006

9

Teck-Hua Ho

Expected Revenue versus Expected Revenue versus Number of BiddersNumber of Bidders

WTPn

nWTPE n

1

1)( )1(

Expected Revenue versus Number of Bidders

020406080

100

0 10 20 30

Number of Bidders (n )

Exp

ecte

d R

even

ue (%

of h

ighe

st W

TP)

April 15, 2006

10

Teck-Hua Ho

Optimal Reserve Price (one Optimal Reserve Price (one seller) (uniform distribution)seller) (uniform distribution)

Optimal reserve price:

If the reserve price is smaller than the second highest WTP, reserve price has no revenue effect on the bidding process

If it is between the highest and the second highest WTPs, it will force the highest bidder to go beyond the second highest WTP (the point where the second highest bidder drops out).

5002

0000,10

2

Good Unsoldof ValueGood Unsoldof Value

WTP

April 15, 2006

11

Teck-Hua Ho

Predicted Versus ActualPredicted Versus Actual Bids Bids and Reserve Priceand Reserve Price

PredictedPredicted

By AuctionBy Auction

TheoryTheory

Actual Actual

BehaviorsBehaviors

Bid as % of WTPBid as % of WTP

(except winners)(except winners) 99% 95.5%

Reserve PriceReserve Price 500 289

April 15, 2006

12

Teck-Hua Ho

Revelation PrincipleRevelation PrincipleRevelation Principle: All buyers (except the winner) end up

revealing their WTPs for the item to the sellers. Put differently, sellers can “discover” distribution of buyers’ WTPs via the auction mechanism. This is not the case for other pricing mechanisms (e.g., seller posted price and priceline model)

Application: Use open English auction to discover the distribution of WTPs and then use seller posted price model to maximize share of surplus

April 15, 2006

13

Teck-Hua Ho

Efficiency PrincipleEfficiency PrincipleEfficiency Principle: The auction mechanism guarantees

that the item always goes to the buyer with the highest WTP in a market. Again, this is not always the case for other pricing mechanisms

(inefficiency = 0% (predicted) versus 1.6% (actual))

Observation: Auction model is likely to dominate the other price models in terms of total social surplus generated.

April 15, 2006

14

Teck-Hua Ho

Maximum Possible Surplus Maximum Possible Surplus (MPS)(MPS)

Seller 1 c=0

Seller 2 c=0

Buyer 1 40 Buyer 2 20Buyer 3 15Buyer 4 90Buyer 5 60Buyer 6 50

WTP

MPS = 40 + 90 + 60 + 50 = 240

April 15, 2006

15

Teck-Hua Ho

The Winning TeamThe Winning Team

The winning team is: Group 4

The prize is:

April 15, 2006

16

Teck-Hua Ho

Disadvantages of AuctionsDisadvantages of Auctions

Can be stressful for some buyers, especially for end consumers (this can be however solved by proxy bidding). Thus, it is less likely to work for low purchase-involvement product categories

There are more losers than winners (and losers are less likely to revisit the website)

Strategic manipulation (e.g., shilling)

April 15, 2006

17

Teck-Hua Ho

Next Class: Design of Auction Next Class: Design of Auction FormatFormat

Dutch auction (D) (e.g, www.landsend.com )

First-price sealed-bid auction (F) (e.g., US Treasury bills, supply contracts; government procurement (10% GDP))

Second-price sealed-bid (Vickrey) auction (S) (e.g., www.sandafayre.com; NZ’s communication spectrum rights)

English auction (E) (e.g., www.ebay.com ; www.yahoo.com )

April 15, 2006

18

Teck-Hua Ho

Ebay’s business modelEbay’s business model

Seller Buyer Seller & BuyerPrice Setting Party

Pri

ce O

ver

Tim

e Stat

icD

ynam

ic

ebay.com

http://www.ebay.com/

April 15, 2006

19

Teck-Hua Ho

Ebay’s Current Status in 2004Ebay’s Current Status in 2004

Listings - New listings totaled a record 348.0 million in Q3-04, 48% higher than the 234.6 million listings reported in Q3-03.

Confirmed Registered Users - Cumulative confirmed registered users at the end of Q3-04 totaled a record 125.0 million, representing a 46% increase over the 85.5 million users reported at the end of Q3-03.

Active Users - Active users, the number of users on the eBay platform who bid, bought, listed or sold an item over the trailing 12 months, increased to 51.7 million, a 38% increase over the 37.4 million active users reported in the same period a year ago.

April 15, 2006

20

Teck-Hua Ho

Ebay’s Original Revenue ModelEbay’s Original Revenue Model

M = Total number of items listed per year

Feei = Insertion fee of item i

Comi = Final value fee of item i

Ii = 1 if item i is sold; 0 otherwise

M depends on number of people in the community

Comi x Ii increases with price or seller surplus

M

iii

M

ii IComFeevenue

11

Re

Revenue Levers

April 15, 2006

21

Teck-Hua Ho

Ebay’s Original Revenue ModelEbay’s Original Revenue Model

Biggest strength of the revenue model:Revenues increase linearly with M but costs do not increase with M.

(scalability property)

April 15, 2006

22

Teck-Hua Ho

Ways to Enhance Ebay’s Ways to Enhance Ebay’s RevenueRevenue Increase M

Increase size of community, Enter new markets and product categories Increase turnover (e.g., reduce bidding duration, encourage setting of

buyout prices)

Increase Feei

Encourage more pictures and promotion of items

Increase Comi

Increase average number of bidders / auction (so as to increase seller surplus)

Encourage high-priced items (e.g., electronics, cars)

Increase Ii

Increase average number of bidders / auction so as to increase the probability that the highest bid > reserve price

Encourage a lower reserve price (e.g., the recent increase in insertion fee for reserve price auction)

April 15, 2006

23

Teck-Hua Ho

EBay’s Revised Revenue ModelEBay’s Revised Revenue Model

Fees to list an item for regular auctions, fees is a function of starting price for vehicles, a function of type of vehicles for real estate, a function of types of properties and listing type

Picture Service Fees—first picture free, additional picture or bigger picture incurs fees

Listing upgrade fees: various options to promote items Final value fees

for regular auction, charged when reserve met, at a function of the closing bid For vehicles, charged when the first bid over the reserve price is placed (regardless

of whether sale is finally made) For real estate, a fixed fee for land/time share where there is successful high bid on

the item and no fees for other type of real estates Reservation Price Fees—charged only if item not sold, a function of reserve

price

M

iii

M

iii

M

ii IRIComFeevenue

111

)1(Re

April 15, 2006

24

Teck-Hua Ho

Ways to Enhance Customer Ways to Enhance Customer ExperienceExperience Bidder Management

Smart search capability to narrow consideration set

Winner ManagementTrust and safety initiatives

Loser Management: For every winner, there are (n-1) losers. Find ways to get them to bid again:Follow-up emails on availability of related items

Seller ManagementLoyalty programs for frequent sellers

April 15, 2006

25

Teck-Hua Ho

Recipe for Continued Market Recipe for Continued Market LeadershipLeadership Liquidity, liquidity, liquidity

Keep Existing Customers HappyIncrease switching costs

Increase post-auction satisfaction

Acquire New CustomersNew markets (e.g., Canada, UK, China, etc.)

New products (especially high-priced items)

Direct acquisition of customers / sites

April 15, 2006

26

Teck-Hua Ho

PunchlinePunchline Open English Auction

Revelation PrincipleEfficiency Principle

Ebay’s Business ModelRevenue increases with seller surplusLiquidity promotes lock-in: Keep existing

customers happy and acquire new customersDiversification: New markets and new products

(especially high-priced items)

April 15, 2006

27

Teck-Hua Ho

Exercise on Revenue Model DesignExercise on Revenue Model Design

Visit google answers: http://answers.google.com/answers/

Figure out its revenue model and levers?

April 15, 2006

28

Teck-Hua Ho

Google Answers’ Revenue ModelGoogle Answers’ Revenue Model

iii

M

i

M

iii

M

i

ADNCSPI 111

%2550.0$Revenue

M = Total number of questions posted per year

$0.50 = A posting fee of 50 cents per question

Ii = 1 if question i is answered; 0 otherwise

Pi = Buyer’s posted price for question i

Si = 1 if question i has sponsored links; 0 otherwise

NCi = Number of clicks for question i

ADi = Average fee per clickhttp://answers.google.com/answers/faq.html#cost