Ch. 3: Auctions in Corporate Finance 89
- Introduction
This paper reviews developments in auction theory, with a focus on applications to
corporate finance. Auctions, viewed broadly, are economic mechanisms that transfer
control of an asset and simultaneously determine a price for the transaction.^1 Auctions
are ubiquitous across the world. Formal auctions are used to buy and sell goods and
services from fish to mineral rights and from logging contracts to lawyers’ services in
class action lawsuits. In the world of finance, auctions are used to buy and sell entire
firms (in bankruptcy and out of bankruptcy) as well as securities issued by governments
and companies. In the most recent and public example of auctions in corporate finance,
the internet search firm Google sold its shares via a Dutch auction method in its initial
public offering.
Auction theory has developed to explore a variety of issues, with the most important
ones relating to pricing, efficiency of the allocation, differential information, collu-
sion, risk aversion, and of course a very large topic, the effects of different auction
rules (sealed-bids versus open auctions, reserve prices, entry fees, etc.) on the revenue
to the seller.^2 Concomitant with theoretical work, there has been significant work in
applications of auction theory, with many of these being related in some way to cor-
porate finance. On one level, application of auction theory to corporate finance is very
natural, for corporate finance sometimes directly involves auctions (e.g., auctions in
bankruptcy). At another level, though, auction theory should serve to inform corporate
finance because the underlying primitive issues are the same: pricing of assets, exchange
of control, uncertainty especially in regard to asset valuation, heterogeneity of agents,
asymmetric or disparate information, and strategic behavior. Given this similarity in the
underlying frameworks, one should expect auction theory to have significant influence,
both direct and indirect, on corporate finance research. There has also been, particularly
in recent years, much work in the estimation of auction models. The econometrics of this
work is very sophisticated, utilizing structural estimation methods that can retrieve es-
timates of the underlying distribution of bidders’ valuations from bid data. While these
techniques have not yet been applied to data from finance-related auctions, there would
seem to be room for application to, for instance, corporate bankruptcy auctions. The
broad lesson from these econometric studies is also very relevant for empirical work
in financial auctions: use the restrictions from the theory to learn more from the data
than non-structural methods will reveal. For this reason, empirical finance researchers
studying auctions should have a good knowledge of auction theory.
(^1) Throughout this survey, we will normally consider auctions where an item is being sold. Reverse auctions,
where an auction is used to purchase an item, can generally be modeled by simply reversing the direction of
payment.
(^2) Krishna (2002)provides an excellent, comprehensive review of all existing auction theory.Klemperer
(2000)is a shorter, recent review of auction theory, whileMcAfee and McMillan (1987)is thorough but a bit
dated by now.