Vickrey Auction

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Vickrey Auction

Vickrey auction is a type of auction which follows the second price mechanism methodology for its bid, which means it is a sealed bid where the proposals submitted are kept secret. Therefore, bidders are not allowed to know the recommendations made by others. However, when a bidder wins the bid, they have to pay the prices of the second-highest bid and not their bid amount, which was the highest.

Explanation

Vickrey auction was coined by William Vickrey, a Canadian and winner of the Nobel Prize in economics in 1996. It is a sealed bid auction but does not follow the traditional rules of a sealed bid auction. Here the bidders are not aware of the bid made by others, and that is kept secret. It is different from the traditional sealed bid option because the bid winner who has called for the highest bid will pay the price of the second-highest bid and not of his bid. The kind of balance amount the bidder who won doesn’t have to pay is a surplus. In such a kind of auction, the bidders are encouraged to pay based on their maximum willingness as anyways they need to pay for the second-highest bid.

Vickrey Auction

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Source: Vickrey Auction (wallstreetmojo.com)

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How Does it Work?

Vickrey auction is a type of auction where all the bidders will bid for their true value or worth and will have the maximum willingness to pay for the highest price to stand as the winner of the bid. The auctionAuctionAuction Market is a marketplace where the buyers and sellers trade stock by bidding. The price is calculated based on the highest amount a buyer is ready to pay and the lowest amount a seller is ready to accept. read more is a sealed bid where no bidder is aware of other bids. Thus everyone contributes willingly and wants to go the extra mile to win the bid. Every bidder will put the maximum bid possible. They are kind of motivated or encouraged to quote a high bid because, anyways, they won’t be paying the highest amount and will only have to pay for the second-highest bid. This will not cause any disadvantage to the bidder for quoting the maximum bid. Thus, we see Vickrey’s auction follows the second price mechanism. By following the second price mechanism, bidders will bid truthfully.

Example of Vickrey Auction

Let us consider a few examples to give a demonstration.

Example #1

Suppose an online bid for the auction of paintings is going live. A bidder places a bid of $5000 for it. Now when a bidder places that amount, he won’t place a bid of more than $5000 because that is the maximum worth according to him for the painting, and he will also not place a higher bid because he might have to end up paying the price higher than his willingness. But, on the other hand, the bidder will also not place a price lesser than $5000 because he might believe that he might lose the bid if he places a lower bid than what he was willing to. Thus we find in Vickrey’s auction the buyer’s willing places a true bid for the item and is motivated to do so to win the bid.

Example #2

Let us suppose an auction for an antique gemstone is going on, and four bidders have got involved in the bidding process. Now, bidder A places a bid of $1500, bidder B places a bid for $2000, bidder C places a bid for $1800, and finally, bidder D places a bid for $1700. It is evident now that bidder B had the highest bid, winning the auction bid. The twist in the Vickrey auction is that although bidder B has won the auction quoting a bid of $2000, he will only pay the sum of the second-highest bid, which is $1800. Thus in this way, he is ending up in surplus money of $200. Thus, in the Vickrey auction every bidder is willingly motivated to call for the highest bid because of the hope to end up retaining surplus money. Therefore, every bidder tries to win the bid and thus places the bid truthfully based on the value of the item and is motivated about doing so.

Importance

The importance is as follows:

  • Bidders quote their bid truthfully and are motivated to do after understanding the real worth or value of the item in the bid.
  • The bid winner ends upon paying less than his bid, so the amount saved is a kind of surplus to the bidder.
  • The item in the bid also gets a good value or return in the auction since every participant wants to put their maximum bid to be declared the winner.
  • Vickrey auction is a dominant strategy for a bidder to opt out of the auction process when the auction prices have reached the maximum level of the bidder’s expected price.

Benefits

  • The winning bidder does not have to pay the maximum price and only pays the second-highest bid.
  • The items in bidding get their true worth and value for the bid.
  • Bidders are self-motivated to place the highest bid and willingly do so.
  • The winning bidder will retain surplus money due to the second price mechanism.
  • It encourages bidders to participate in an auction and motivates them to call for a good bid.

Conclusion

Vickrey auction is an effective way of conducting an auction though it is very rare and happens only on limited occasions. It follows the second price mechanism, which encourages bidders to bid willingly and motivates them to win. The item in bidding also ends up getting its true value or worth.

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