Market and auction design constitute important aspects of social welfare instruments in modern economies as they determine the allocation of surplus between producers and consumers, whether the right framework for certain markets exist for such markets to come into existence and how competitive and tightly regulated those markets will be.

During the past two decades, economic research and ideas have played an increased role in market organisation and design, in instances like:

  • spectrum auctions;
  • tradable permit systems for pollution abatement;
  • internet search advertising;
  • market mechanisms for innovation;
  • centralised systems for the allocation of organs; and
  • formal procedures for student assignment.

While studying how societies allocate resources, economics often looks at markets as given. However, while certain allocation problems are solved by the market mechanism and the prices that it results in (for instance the attraction of workers into an occupation through high wages), in some instances price systems encounter legal, ethical and social welfare problems or objections (as is the case, for example, in human organ allocation with respect to patients requiring a transplant or the selling of a vote). Market design, dealing with the allocation of resources in the absence of markets or in instances of market failure, combines economic and game theory with empirical work and experimental analysis. Alvin Roth and Lloyd Shapley earned the 2012 Nobel Prize in economics for their research in this field. It also deals with competition incentivisation and replication, price control regimes for the achievement of desirable public policy outcomes,  the granting of access to essential facilities and the terms and conditions on the basis of which such access is granted, as well as the establishment of standards and institutions to ensure inter-compatibility, inter-connectivity and trust.

Three properties of chief importance for market design are the institutional context within which they take place, stability and incentive compatibility. The institutional context determines the type of markets one can expect to develop over time. In the absence of strong and trusted institutions, for instance, certain socially-contrived markets that depend on the impartial enforcement of contracts, such as the financial markets, cannot be expected to develop. Moreover, stability encourages groups to voluntarily participate in the market while incentive compatibility discourages the strategic manipulation of the market. It is also important to note that stable matchings always exist and are relatively easy to construct. The most famous algorithm used to match markets is the deferred acceptance algorithm. This algorithm always yields the best possible stable matching for actors/traders whose preferences are taken into account. This means that these would prefer the result of this matching process to any other stable matching.

Auctions are some of the oldest market forms. In this area, economists differentiate between:

Private-value auctions, where every participant has a potentially different value for the good being auctioned; and

Common-value auctions, where the auctioned good is essentially worth the same to all the bidders, even though different bidders may have different estimates of that worth. In this auction type, the bidder who overestimates an object’s value most wins the bidding. This has accordingly been termed the winner’s curse.

The economic study of auctions revolves mainly around four main types
of auctions:

The English auction – here, the auctioneer begins with a reserve price, representing the lowest price at which the good’s seller is willing to sell it. Bidders would then offer successively higher prices. When no bidder wants to raise the bid further, the auctioned good is given to the last (and highest) bidder;

The Dutch auction – in this auction type, the auctioneer commences with a high price and lowers it in successive discrete steps until someone is willing to buy the good. The auctioneer frequently makes use of a mechanical device such as a dial with a pointer rotating to lower amounts as the auction progresses or a digital counter to the same effect;

The sealed-bid auction – in this type of auction, every bidder writes down a bid. The envelopes containing the bids are collected and opened, with the auctioned item then being given to the highest bidder. This bidder pays the auctioneer the bid amount. If a reserve price had been established and all bids are less than the reserve price, then no bidder receives the item. Sealed-bid auctions are frequently used for construction work. The person wanting the construction work done requests bids from contractors with the understanding that the contract will be given to the contractor offering the lowest bid;

The Vickrey auction – this is a variant of the sealed-bid auction. The difference between them is that in a Vickrey auction, the good is awarded to the person bidding highest, but at the second-highest price. The Vickrey auction was deemed to be of limited importance until online auctions became popular. When utilising a bidding agent or an auction sniper to monitor and manage the auction process, as is common, for instance, on Ebay, bidders instruct their bidding agent about the sum they are prepared to pay for a good and a first bid. As the bidding advances, when necessary, the bidding agent increases a participant’s bid by the minimum allowable bid increment, providing that this does not increase the participant’s bid over his/her maximum. In theory, every bidder in a Vickrey auction has an incentive to reveal his/her true value for the auctioned good. However, in practice, bidder behaviour is slightly different as frequently, the auction participants or their digital agents wait until close to the end of the auction to submit their bids.
With respect to auction design, there are, in general, two goals one might hope to attain:

Pareto efficiency – this essentially means that an allocation cannot make a person better off without making another one worse off. English auctions and Vickrey auctions are acknowledged to have Pareto efficient outcomes; and

Profit maximisation – generally, a reserve price is required for this goal to be achieved.
In spite of their benefits as market mechanisms, auctions are susceptible to collusion and other types of strategic behaviour by participants.

Equinox Advisory provides the following market and auction design support for governments and companies:

  • Assessment of the institutional contexts within which a market needs to be introduced;
  • Institutional design for supporting the development of specific markets;
  • Advise on market reforms to achieve specific public policy objectives;
  • creation of new market processes, such as auctions and trading systems, which are consistent with the client’s objectives and policies;
  • advice on the choice of auction format, bidding rules and procedures;
  • advise on marketing and administering applications, as well as running the auction;
  • assisting clients with the provision of input to regulators on auction design;
  • teaching clients about auctions and their technicalities;
  • providing strategic and logistical help with the development and implementation of a bidding strategy; and
  • on-site support to clients throughout each auction.

For more information about our Market & Auction Design services, please contact us here.