9781118041581

The Advantages of Auctions 671

Roughly speaking, auctions occupy a middle ground between posted pric-

ing and negotiated prices. A common means of sale (and the universal means

for U.S. retail sales) is for sellers to post prices, leaving buyers the choice to

purchase at that price or not at all. Ideally, posted prices should be set in line

with supply and demand. But given the difficulty in judging these forces (or

changes in them), this is not always the case. At the other extreme are negoti-

ated prices, which are freely flexible. Although it has obvious advantages, pric-

ing flexibility also has its costs. Negotiations can be time-consuming and

expensive. Moreover, in the bargaining process, both buyer and seller have a

significant influence on the final price. If everything is negotiable, a seller sur-

renders much of its monopoly power over price.

Auctions can be viewed as combining the best of the posted and negoti-

ated pricing worlds. An auction ensures that competition among buyers sets

the final price—the highest price the market will bear. In effect, the auction

allows the seller to compare all buyer offers simultaneously and choose the

best one. The auction is less time-consuming than rounds of one-on-one nego-

tiations, and it preserves the seller’s monopoly position. Auctions are more

flexible than posted pricing. The current state of market demand determines

the good’s price, not the seller’s best guess as to demand. The following exam-

ples illustrate these points.

A STOCK REPURCHASE A company is considering buying back a portion of

its common stock. Top management believes the value of its company’s stock

to be about $80 per share. (The current market price of $67 is indicative of

the market’s “undervaluing” the firm’s shares.) Management is considering

offers to buy back shares at one of three possible prices: $70, $72, and $74.

However, there is a great deal of uncertainty about how many shares might be

tendered at these prices. The following table lists the number of shares ten-

dered (in millions) at the different prices for three kinds of shareholder

response: strong, medium, and weak. Management does not know which of

the cases will hold; its best prediction is that all three are equally likely.

The company reckons its profit from any repurchase at ($80 P)Q, where

P is the price it pays and Q is the quantity of shares it succeeds in buying. What

price offer should the firm make to maximize its expected profit?

Shareholder Response

Price Strong Medium Weak

$70 13 9 6

72 14 12 8

74 18 15 12

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