Tuesday, April 12, 2011

The Two Principles

Our auctions unit highlighted two principles: The Revenue Equivalence Principle and The Linkage Principle. The Revenue Equivalence Principle is a handy result allowing us to compare all sorts of auctions. It roughly says this:

Any auction where: (1) High bidder wins; (2) Free opt-out; (3) Bidders are similar; and (4) Bids are for cash yields the same expected revenue as a Vickrey auction. In fact, it says something a little stronger. It says that the expected payment for a bidder with value v is the same across auction forms. This auction pulls together a lot of non-auction settings such as price wars, R&D races, waiting times in line, and so on. It should be viewed as a first step and not a final answer. For instance, risk aversion will "break" the result. Bidders who differ a lot (i.e. one bidder known to be high value with a competitive fringe surrounding) will break the result. Multiple units that differ from one another (i.e. the slot auction) will break the result. But it's an essential starting point.

Our second principle was linkage. This roughly states that the more linked a bidder's payment is to value, the more revenues the auctioneer earns. We saw this sharply in comparing debt to equity. Since equity has linkage, it yields more money. It can also be used for disclosure strategies when values are correlated. For instance, suppose that an auctioneer is selling rights to an oil tract. Here, bidders have a common value for the tract (equal to the amount of oil under it). The linkage principle says that the auctioneer is better off, on average, if it reveals information about the value of the tract (i.e. seismological studies) than when it does not. In other words, disclosure is the best policy even if it means sometimes disclosing unfavorable information.

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