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Lecture 11: Auction Theory

Advanced Microeconomics II


Osaka University, Department of Economics yasuda@econ.osaka-u.ac.jp

January 13, 2015



Imagine that there is a (potential) seller who has a painting that is worth nothing to her personally. She hopes to make some money by selling the art through an auction.

Suppose there are two potential buyers, called bidders 1 and 2. Let x1 and x2 denote the valuations of the two bidders. If bidder i wins the painting and has to pay b for it, then her payoff is xi− b.

where x1 and x2are chosen independently by nature, and each of which is uniformly distributed between 0 and 1. The bidders observe their own valuations before engaging in the auction. The seller and the rival do not observe a bidder’s valuation; they only know the distribution.

In what follows, we study two prominent sealed-bid auctions: a first-price auction and a second-price auction.

The former is commonly used while the latter has great

theoretical importance and started to be applied in reality. 2 / 15


First-Price Auction (1)

Bidders simultaneously and independently submit bids b1 and b2. The painting is awarded to the highest bidder i with max bi , who must pay her own bid, bi.

To derive a Bayesian Nash equilibrium, we assume the bidding strategy in equilibrium is i) symmetric, and ii) linear function of xi. That is, in equilibrium, player i chooses

β(xi) = c + θxi. (1)

Now suppose that player 2 follows the above equilibrium strategy, and we shall check whether player 1 has an incentive to choose the same linear strategy (1). Player 1’s optimization problem, given she received a valuation x1, is

maxb1 (x1− b1) Pr{b1 > β(x2)}. (2)


First-Price Auction (2)

Since x2 is uniformly distributed on [0, 1] by assumption, we obtain Pr{b1 > β(x2)} = Pr{b1 > c+ θx2}

= Pr b1− c θ > x2

= b1− c θ .

The first equality comes from the linear bidding strategy (1), the third equality is from the uniform distribution. Substituting it into (2), the expected payoff becomes a quadratic function of b1.

maxb1 (x1− b1)

b1− c θ

Taking the first order condition, we obtain du1


= 1

θ[−2b1+ x1+ c] = 0 ⇒ b1= c 2 +


2 . (3)

Comparing (3) with (1), we can conclude that c = 0 and θ = 12 constitute a Bayesian Nash equilibrium.

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Second-Price Auction

Bidders simultaneously and independently submit bids b1 and b2. The painting is awarded to the highest bidder i with max bi , at a price equal to the second-highest bid, maxj6=ibj.

Unlike the first-price auction, there is a weakly dominant strategy for each player in this game.

Theorem 1

In a second-price auction, it is weakly dominant strategy to bid according to β(xi) = xi for all i.

Since the combination of weakly dominant strategies always becomes a Nash equilibrium, bi = xi for all i is a BNE.

Rm Note that there are other asymmetric equilibria.

For example, β1(x1) = 1 and β2(x2) = 0 for any x1 and x2

constitute a Bayesian Nash equilibrium.


Expectation (1)

Definition 2

Given a random variable X taking on values in [0, ω], its

cumulative distribution function (CDF) F : [0, ω] → [0, 1] is: F(x) = Pr[X ≤ x]

the probability that X takes on a value not exceeding x.

F is non-decreasing F(0) = 0 and F (ω) = 1.

We assume that F is increasing and continuously differentiable.

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Expectation (2)

Definition 3

If X is distributed according to F , then its expectation is E[X] =

Z ω 0


= Z ω



and if γ : [0, ω] → R is some arbitrary function, then the expectation of γ(X) is analogously defined as

E[γ(X)] = Z ω


γ(x)f (x)dx

= Z ω


γ(x)dF (x)



Expectation (3)

Definition 4

The conditional expectation of X given that X < x is E[X | X < x] = 1

F(x) Z x



which can be rewritten as follows (by integrating by parts): F(x)E[X | X < x] =

Z x 0


= xF (x) − Z x


F(t)dt. The conditional expectation of γ(X) is defined as

E[γ(X) | X < x] = 1 F(x)

Z x 0

γ(t)f (t)dt.

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Order Statistics

Let X1, X2, . . . , Xnbe n independent draws from a distribution F with associated probability density function (PDF) f (= F).

Let Y1, Y2, . . . , Yn be a rearrangement of these so that Y1≥ Y2 ≥ · · · ≥ Yn.

Yk is called kth(-highest) order statistic.

Let Fk denote the distribution of Yk (with its pdf fk). The distribution of the highest order statistic is

F1(y) = F (y)n

f1(y) = nF (y)n−1f(y).

The distribution of the second-highest order statistic is F2(y) = F (y)n+ nF (y)n−1(1 − F (y))

= nF (y)n−1− (n − 1)F (y)n. f2(y) = n(n − 1)(1 − F (y))F (y)n−2f(y).


Expected Revenue: First-Price

In a first-price auction, the payment is max{12X1,12X2} . Recall that β(xi) = 12xi is a BNE.

max{12X1,12X2} = 12max{X1, X2} = 12Y1. The expectation of Y1 becomes

E[Y1] = Z 1



= Z 1


2y2dy= 2 3y




= 2 3.

The expected revenue of the first-price auction is 1 3 (=

1 2×

2 3).

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Expected Revenue: Second-Price

In a second-price auction, the payment is min{X1, X2} .

Recall that β(xi) = xi, i.e., trugh-telling is a BNE. min{X1, X2} = Y2.

The expectation of Y2 becomes E[Y2] =

Z 1 0


= Z 1


y× 2(1 − y)dy = Z 1


2(y − y2)dy

= 2  1 2y




 1 3y





= 1 3.

The expected revenue of the second-price auction is 1

3, which is identical to the expected revenue of the first-price auction!.


Revenue Equivalence Theorem

The two sealed-bid auctions, first-price and second-price auctions, have different equilibrium bidding strategies but yield the same expected revenue.

Interestingly, this is not by chance; the revenue equivalence result, often called as “revenue equivalence theorem (RET)”, is known to hold in much more general situations.

Theorem 5

RET holds whenever the following conditions are satisfied: Private Value Each bidder knows her value of the object. Independent Bidders receives their values independently. Symmetric The distribution is identical among bidders. Risk Neutral Each bidder is risk neutral.

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First-Price: General Model (1)

Consider a first-price auction with n bidders in which all the conditions in the previous theorem are satisfied.

Assume that bidders play a symmetric equilibrium, β(x). Given some bidding strategy b, a bidder’s expected payoff becomes

(x − b) Pr{b > Y1n−1} = (x − b) × G(β−1(b))

where Y1n−1 is the highest order statistic among n − 1 random draws of the values and G is the associated distribution. Maximizing w.r.t. b yields the first order condition:


β−1(b))(x − b) − G(β−1(b)) = 0 (4) where g = G is the density of Y1n−1.


First-Price: General Model (2)

Since (4) holds in equilibrium, i.e., b = β(x), g(x)

β(x)(x − b) − G(x) = 0 ⇐⇒ G(x)β(x) + g(x)β(x) = xg(x), which yields the differential equation


dx(G(x)β(x)) = xg(x).

Taking integral between 0 and x, we obtain

Z x 0


dy(G(y)β(y))dy =

G(x)β(x) − G(0)β(0) = Z x



⇒ β(x) = 1 G(x)

Z x 0

yg(y)dy = E[Y1n−1| Y1n−1 < x].

Rm The equilibrium strategy is to bid the amount equal to the conditional expectation of second-highest value given that my value x is the highest.

14 / 15


First-Price: General Model (3)

The expected payment (to the seller) of each bidder given x is G(x) × E[Y1n−1| Y1n−1 < x],

which is identical to that of the second-price auction.

Rm The expected revenue is just the aggregation of the expected payment of all bidders, it can be derived by

n× Z ω


G(x) × E[Y1n−1| Y1n−1 < x]f (x)dx

= n Z ω


G(x) × 1 G(x)

Z x 0



= n Z ω


Z x 0


f(x)dx = n Z ω


Z ω y



= n Z ω


y(1 − F (y))g(y)dy = Z ω



⇒ E[Y2n] since f2(y) = n(1 − F (y))f1n−1(y).