90 S. Dasgupta and R.G. Hansen
A careful review of the literature shows that auction theory has had a significant but
not overwhelming influence on corporate finance. Perhaps the more insightful appli-
cations have been in the context of corporate takeover bidding: pre-emptive bidding,
means of payment (takeover auctions are not always financed with cash), bidder het-
erogeneity, and discrimination amongst bidders. Application of auction theory to these
contexts has at times produced new insights. Overall, however, while the applications
have extended our understanding of the inefficiencies that are due to the underlying
primitive construct of private information, they have not changed that understanding in
any fundamental way.
The survey proceeds as follows. Section2 reviews the simplest auction setting, that
of independent private values. Many key insights can be developed from this simplest
model: the basic pricing result that an auction’s expected price equals the expected
second-highest value; general solution methodology; effects of more bidders’ risk aver-
sion, reserve prices; revenue equivalence of the different auction forms; revenue en-
hancement from ex-post means-of-payment; and the solution of auction models via the
Revelation Principle. Section3 considers the interdependence amongst bidders’ val-
uations (including the special case of a “common value” for the object) and reviews
Milgrom and Weber’s (1982a, 1982b)generalized auction model. Critical insights in
this section pertain to the effects of the winner’s curse; that lack of disclosure by the
seller can lower expected prices; and that the different auction forms are no longer
revenue-equivalent. With the basic theory developed in these sections, Section4 turns
to the applications most relevant to corporate finance. Section5 ends with some thoughts
about future applications and further development of auction theory that would make it
more relevant for corporate finance.
- The most basic theory: Independent private values
2.1. Initial assumptions
Auction theory begins with assumptions on how bidders value the asset for sale; the
model then shows how an auction converts valuations into a price and an exchange of
control. Valuation assumptions are absolutely key to auction theory. However, as we
will argue later, the existing paradigms are not complete as they do not consider certain
sets of valuation assumptions that are particularly relevant in corporate finance.
Independent preference (sometimes called independent private values) assumptions
are straightforward: each bidder is simply assumed to know her value for the asset. For
bidderi, denote this value asvi. While each bidder knows her own value, to make the
situation realistic and interesting, we assume that a bidder does not know other bidders’
values. To model this uncertainty, we assume that each bidder believes other bidders’