Auction theory

Auction theory is an applied branch of economics which deals with how people act in auction markets and researches the properties of auction markets. There are many possible designs (or sets of rules) for an auction and typical issues studied by auction theorists include the efficiency of a given auction design, optimal and equilibrium bidding strategies, and revenue comparison. Auction theory is also used as a tool to inform the design of real-world auctions; most notably auctions for the privatization of public-sector companies or the sale of licenses for use of the electromagnetic spectrum.

Auctions are characterized as transactions with a specific set of rules detailing resource allocation according to participants' bids. They are categorized as games with incomplete information because in the vast majority of auctions, one party will possess information related to the transaction that the other party does not (e.g., the bidders usually know their personal valuation of the item, which is unknown to the other bidders and the seller). Auctions take many forms, but they share the characteristic that they are universal and can be used to sell or buy any item. In many cases, the outcome of the auction does not depend on the identity of the bidders (i.e., auctions are anonymous).

Most auctions have the feature that participants submit bids, amounts of money they are willing to pay. Standard auctions require that the winner of the auction is the participant with the highest bid. A nonstandard auction does not require this (e.g., a lottery).

There are traditionally four types of auction that are used for the allocation of a single item:

Most auction theory revolves around these four "basic" auction types. However, other auction types have also received some academic study (see Auction Types).

The benchmark model for auctions, as defined by McAfee and McMillan (1987), offers a generalization of auction formats, and is based on four assumptions:

The benchmark model is often used in tandem with the Revelation Principle, which states that each of the basic auction types is structured such that each bidder has incentive to report their valuation honestly. The two are primarily used by sellers to determine the auction type that maximizes the expected price. This optimal auction format is defined such that the item will be offered to the bidder with the highest valuation at a price equal to their valuation, but the seller will refuse to sell the item if they expect that all of the bidders' valuations of the item are less than their own.

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