SMU SOE Seminar (Nov 11, 2016): Low Reserve Prices in Second- Price Auctions

    A common empirical observation is that reserve prices in auctions often seem to be lower than received auction theory would predict. In this paper, we address this "low reserve" puzzle by extending the theory to include both interdependent values and risk averse bidders. Focusing on second-price auctions, we find that if the bidders are sufficiently risk averse, or if their values are sufficiently interdependent, a profit-maximizing reserve price can be lower than the seller's value for the auctioned object, and arbitrarily close to the zero reserve price of an absolute auction. This result stems from the fact that in a second-price auction, value interdependence causes the lowest bid a bidder will ever make to be strictly larger than the reserve price, and this "gap" increases with bidder risk aversion. If the gap is large enough, lowering the reserve price will, paradoxically, increase each bidder's ex-ante expected payment to the seller, because it increases the likelihood he will pay the higher second-highest bid, rather than the lower reserve price

Keywords: Auction Reserve Prices, Received Auction Theory, Risk Aversion, Profit Maximising