Vickrey Auction is a special type of silent auction in which the goal of the auction is to achieve the highest possible price for the seller by motivating bidders to bid truthfully. We explain below how the Vickrey auction differs from a standard auction where the highest bid wins and equals to the price paid.
The highest bid wins in Vickrey auction as well, but the final price paid for the good is equal to the second highest bid. What are the benefits of this system and of the Vickrey auction? Read below.
What is Vickrey auction
Vickrey auction is a sealed-bid auction in which each participant simultaneously submits his or her bid. This is the same concept like in any other standard sealed-bid auction. Vickrey auction is however a "second price" auction. The price paid for the exchanged good is equal to the second-highest bid placed.
The Vickrey auction is named after Canadian national William Vickrey who first described this concept in his paper in 1961 and pointed out benefits of the Vickrey auction. The Vickrey auction is also often called second-price sealed-bid auction. William Vickrey received a Nobel Prize for his work.
How Vickrey auction works
Now let's get to the details and explain how the Vickrey auction works.
Regular silent auction...
But first, let's take a look at how a regular silent auction works. Let's say you are selling a MP3 player with Elvis Presley songs on it. The bidders which you have invited into the auction place their bids in sealed envelopes. After collecting all bids, you sell the MP3 player with Elvis Presley songs to the highest bidder for the price that he bid.
This seems reasonable like a way most people would do, right? Now imagine what happens if all your bidders think that your MP3 player is highly valuable but they think they are the only ones who think so. Joe thinks: "I know the MP3 player comes with Elvis Presley songs on it and therefore is very valuable, but all the other guys just see it as a whatever MP3 player." George thinks the same. Martin thinks the same.
In such a scenario, everyone will bid much LESS then he or she really thinks the MP3 player is worth. As a result of their behavior, everyone bids less then how much they value your MP3 player, and the auction will not be efficient.
Now see how the Vickrey auction changes the situation. Vickrey auction sells the MP3 player to the highest bid but for the second highest bid. The Vickrey auction makes the bidders to bid truthfully. With the Vickrey auction, the winning bidder can never affect the price he or she pays, so there is no incentive for any bidder to misrepresent his value.
The amount the bidder bids in Vickrey auction determines only whether he or she wins, and only by bidding his or her true value can he or she be sure to win exactly when he or she is willing to pay the price. In other words, Vickrey auction motivates the bidder to bid at his or her maximum value because he or she knows he or she will pay less in the end anyway. Vickrey auction rules induce people to bid what they think an object is truly worth.
Vickrey auction summary...
The psychological concept behind the Vickrey auction is that if you participate in a Vickrey Auction, you can safely bid the maximum price that you are willing to pay, and you know that if you win, you will pay less than what you bid. If everyone in a Vickrey auction understands this concept, they will all bid the maximum they can afford. The seller will receive the maximum he or she can get. Furthermore, no bidder ends up paying more than he or she can afford.
Vickrey auction example
Good example of (generalized) Vickrey Auction is Google AdWords. eBay's system of proxy bidding is also similar to a Vickrey auction.
Let's say there is an auction of 3 people: Joe bids $10, George bids $20, and Bill bids $30. In this case, Bill wins the bid but pays only $20.
Benefits of Vickrey auction
The practice has shown that human psychological quirks and not just supply and demand drive auctions. Vickrey auction mechanism reduces the likelihood that a bidder will overpay for an item. Vickrey auction also increases the likelihood that the seller will get the most he can get for his item.
Vickrey auction weaknesses
Vickrey auction is vulnerable to bidder collusion. If all bidders in Vickrey auction get together, they can get an idea from each other what everyone thinks the true value of the auctioned item is. As a result, they can lower their valuation.
Vickrey auction is also vulnerable to shill bidding. If you have one bidder with two accounts, he can use one account to bid high to secure the winning position and then use the other account to minimize the price he will pay for the auctioned item.
Auction psychology and tips
Economists have been studying auctions for long time. Classical auction theory suggests that sellers should never set an auction opening price below the value they think is true. Uri Simonsohn and Dan Ariely found out that eBay sellers do precisely the opposite - they set low opening prices to provoke the herd.
These two economists studied eBay auctions and looked at a population of auctions with a starting price of around $45. Auctioned items were also available for a take-it-or-leave-it price of $125 (the "Buy It Now" option). The data has shown that more than 40 percent of the time the auctions produced prices higher than those available with the Buy It Now option. It seems bidders caught up in the moment, evidently forgot they could get the auction item cheaper instantly.
Sellers of DVDs found out that many eBayers illogically prefer auctions with more bidders. Based on Simonsohn's and Ariely's research, a DVD that started at $1 but is now priced at $8 had a 91 % chance of attracting another bid. But when the opening price for a similar DVD was set at $8, that auction had only a 76 percent chance of attracting another bid.
Vickrey auction and what else?