Final Report Summary - AUCTIONS AND INVEST. (Auctions with Investments: Timing and Information)
Auctions are important and widely used trading mechanisms. The following classes of examples are particularly relevant for the current project: Auctions are commonly used in procurement by public agencies and all levels of government, and increasingly, private businesses. Public assets are frequently sold or leased via auctions, including mobile phone licenses and mineral extraction rights. In many instances, bidders have opportunities for investments in relation to an auction. For example, firms may invest in research and development (R & D) prior to bidding for public procurement in order to reduce their costs or improve the quality of the goods and services they are offering. This project studies investments in auctions. The main objective is to further understand bidders’ incentives for investment and how these incentives interact with the auction rules and the consequences in terms of efficiency and the seller’s revenue (or the cost of procurement). This understanding will have both theoretical and practical implications in terms of auction design.
Standard auction models assume that the number of bidders and the information they possess are exogenously given. These models have provided very useful benchmarks. In many environments, however, the number of bidders who will participate in an auction and the participating bidders’ valuations are endogenously determined. This observation has important implications, both practical and theoretical. For example, it is possible that an auction allocates the object to the highest valuation bidder, and hence be efficient for a given set of bidders, but nevertheless be inefficient because a potential bidder with a higher valuation chooses not to participate in the auction. An auction that maximizes the seller’s revenue for a given set of bidders may fall short if it fails to attract enough bidders in the first place. There may be too much entry, wasting valuable resources, or too little, decreasing the benefits hoped to be achieved by using an auction. Consequently, endogenizing entry decisions in auctions is valuable for both theoretical and empirical studies, as well as for practical market design.
The distinguishing features of this research project compared to the previous literature are allowing private information at the time of investment and studying the timing and observability of investments:
(1) Private information: It is natural that firms have some private information at the time of their investment decisions. Firms typically know more than their competitors about their own costs and the returns on their investments, as they know more about their own characteristics such as financial health, human capital, capacity constraints, etc. These issues are especially relevant for large-size public procurement auctions and sales of public assets, like mobile phone licences. The literature so far has assumed that firms are symmetrically informed when they make investment decisions. Incorporating private information at the investment stage is be a key ingredient of the proposed research.
(2) Timing: In many instances firms have the opportunity to make cost-reducing investments after the procurement auction, which in turn affects how much they bid in the auction. This is directly compared with the pre-auction investment case, which has been the sole focus of the previous literature. Moreover, an interesting case we study is when firms can actually choose the timing of their investments: before, after, or both.
(3) Observability: When investments are observable, commitment possibilities arise. It is important to have direct comparisons of two extreme cases of observable and unobservable investments in the same model, which has not been possible so far in the literature. In addition, intermediate cases (where it is observable that a firm had invested, but not the exact amount) will be studied. Another possibility is to make observability a choice variable, and thus investigating the firms’ incentives to signal their intention of how they will behave in the auction.
This general framework furthers our understanding of investments related to auctions: What are firms’ incentives to invest? Do they prefer investing before or after the auction; observable or unobservable investments? Will they try to deter entry by over-investing? Will more efficient firms invest more, and be more successful in the auction? Would the seller rather have firms investing before or after the auction?
The research project is theoretical. It also aims to help future empirical studies of investments and entry in auctions. It is also of interest to policy makers, given that auctions are widely used in government procurement and in selling public assets, and public procurement is a significant economic activity in most countries. Notice that investment opportunities are ubiquitous in these settings. Studying investment and costly entry in auctions also has indirect benefits by contributing to the understanding of endogenous determination of market structure in general, which in turn has implications for competition and regulation policies.
Dr. Yilankaya and Prof. Guofu Tan (USC, USA) have a model of a “second-price auction with investments” that captures the salient features of investments in auction settings and that is also tractable. In this model, the bidders do have private information when they make investment decisions. The necessary ingredients in defining two incomplete information games are there: The first in which bidders invest before the auction, and the second where they invest after. The equilibria of these well-defined games have been found and their properties are currently being studied. According to their preliminary findings, the level investment is higher if made after the auction. Bidders are better off in the “investment-after-the auction” scenario. The seller (or the buyer in procurement auctions) may be better or worse off depending on the parameters, for example the number of bidders. These are the general results obtained given the model. In a leading example, investing after is better in terms of ex-ante efficiency.
Standard auction models assume that the number of bidders and the information they possess are exogenously given. These models have provided very useful benchmarks. In many environments, however, the number of bidders who will participate in an auction and the participating bidders’ valuations are endogenously determined. This observation has important implications, both practical and theoretical. For example, it is possible that an auction allocates the object to the highest valuation bidder, and hence be efficient for a given set of bidders, but nevertheless be inefficient because a potential bidder with a higher valuation chooses not to participate in the auction. An auction that maximizes the seller’s revenue for a given set of bidders may fall short if it fails to attract enough bidders in the first place. There may be too much entry, wasting valuable resources, or too little, decreasing the benefits hoped to be achieved by using an auction. Consequently, endogenizing entry decisions in auctions is valuable for both theoretical and empirical studies, as well as for practical market design.
The distinguishing features of this research project compared to the previous literature are allowing private information at the time of investment and studying the timing and observability of investments:
(1) Private information: It is natural that firms have some private information at the time of their investment decisions. Firms typically know more than their competitors about their own costs and the returns on their investments, as they know more about their own characteristics such as financial health, human capital, capacity constraints, etc. These issues are especially relevant for large-size public procurement auctions and sales of public assets, like mobile phone licences. The literature so far has assumed that firms are symmetrically informed when they make investment decisions. Incorporating private information at the investment stage is be a key ingredient of the proposed research.
(2) Timing: In many instances firms have the opportunity to make cost-reducing investments after the procurement auction, which in turn affects how much they bid in the auction. This is directly compared with the pre-auction investment case, which has been the sole focus of the previous literature. Moreover, an interesting case we study is when firms can actually choose the timing of their investments: before, after, or both.
(3) Observability: When investments are observable, commitment possibilities arise. It is important to have direct comparisons of two extreme cases of observable and unobservable investments in the same model, which has not been possible so far in the literature. In addition, intermediate cases (where it is observable that a firm had invested, but not the exact amount) will be studied. Another possibility is to make observability a choice variable, and thus investigating the firms’ incentives to signal their intention of how they will behave in the auction.
This general framework furthers our understanding of investments related to auctions: What are firms’ incentives to invest? Do they prefer investing before or after the auction; observable or unobservable investments? Will they try to deter entry by over-investing? Will more efficient firms invest more, and be more successful in the auction? Would the seller rather have firms investing before or after the auction?
The research project is theoretical. It also aims to help future empirical studies of investments and entry in auctions. It is also of interest to policy makers, given that auctions are widely used in government procurement and in selling public assets, and public procurement is a significant economic activity in most countries. Notice that investment opportunities are ubiquitous in these settings. Studying investment and costly entry in auctions also has indirect benefits by contributing to the understanding of endogenous determination of market structure in general, which in turn has implications for competition and regulation policies.
Dr. Yilankaya and Prof. Guofu Tan (USC, USA) have a model of a “second-price auction with investments” that captures the salient features of investments in auction settings and that is also tractable. In this model, the bidders do have private information when they make investment decisions. The necessary ingredients in defining two incomplete information games are there: The first in which bidders invest before the auction, and the second where they invest after. The equilibria of these well-defined games have been found and their properties are currently being studied. According to their preliminary findings, the level investment is higher if made after the auction. Bidders are better off in the “investment-after-the auction” scenario. The seller (or the buyer in procurement auctions) may be better or worse off depending on the parameters, for example the number of bidders. These are the general results obtained given the model. In a leading example, investing after is better in terms of ex-ante efficiency.