Thursday, 23 July 2009

Why you should never buy at an auction

Well, almost never. At the very least you should go in with eyes wide open and a decent understanding of the economics behind what you are doing.

The bottom line is that most auctions are devices used to extract maximum price from buyers. I am talking about the types of auctions you get on eBay or at Sotheby's or most commonly house sales.

Conduct an bit of lateral thinking and try do think of the types of things you would do if you were trying to extract a high price for something you are selling.

Well, first of all, the object for sale in an auction must have a decent measure of uncertainty attached to its value, either because there are questions over supply, or maybe it has very heterogeneous qualities that make comparison with alternatives difficult (like a house). In such cases there will always be a wide range of valuations placed on the object by potential buyers, in addition to the estimate of the seller.

If you are the seller in such circumstances, the best way to sell such an object would be to convince everyone to tell you what they would be willing to pay and then strike a deal at the highest price. But try that and see how far you get. Buyers will generally be smart enough to be cagey and pitch a lower number.

So as a seller how do you get around this conundrum. Well, what you want to do is some of the following:

  • Gather as many potential buyers together in the same place
  • Do not provide any real indication of your valuation
  • Have them openly declare their valuations to you and all other potential buyers
  • Make it possible for people to revise their valuation (or there declaration that they make) up
  • Limit the amount of time people have to evaluate information about price competition
  • Retain the right to accept or reject any bid

That pretty much describes an auction. That would pretty much set you up to fleece as much money as you can out of those who would be interested in buying.

Combining these qualities in the sales process:

  • uses competition among the potential buyers to make the person with the highest valuation reveal themselves.
  • uses uncertainty and a lack of information to push up bidder's valuations (bidders can take high levels of bidding competition as "information" that they have underestimated the value of the item - i.e. promote a bidding frenzy)
  • allows new information to increase the price only (if bidder declare they are dropping out of the process, you can't revise you view of the level of interest from competing bidders).
  • prevents a more objective assessment of information (once the gavel falls, the item is sold and you can't renege after thinking about things outside the pressure of the auction).

It is for these reasons that the phrase "Winner's Curse" was coined. To win an auction under such circumstance means you have almost certainly paid too much. The seller has played you as a way of finding out who will pay most (and possibly made you pay more than you thought the object worth) and instantly locking you into a promise to pay that price.

And we haven't even touched on the potential for manipulation by throwing in false signals about bidders' valuations - the sometimes illegal practice of false bidders.

So don't be a mug. Boycott auctions.

Or, if you read this carefully, do it in the right way. Go to lots of auctions for stuff you really want. Ignore whatever is going on around you - there is no information of use in an auction. And one day you will find the very rare combination of:

  • A desperate seller
  • A shortage of bidders

Then you might turn the tables.

No comments: