Chapter 15: Risk Analysis: Walking Through the Fog
Five hundred acres of farmland are being auctioned. There are three individuals willing to bid on the land — Oliver Wendell Douglas, John Kent, and Owen Lars. Douglas is willing to pay $4,000 per acre, Kent is willing to pay $4,200 per acre, and Lars is willing to pay $5,000 per acre. To determine who ultimately purchases the land in an English auction and how much the individual pays, you take the following steps: 1. All three individuals will bid as long as the price is $4,000 or less.
All three individuals are willing to pay less than $4,000 for the land.
2. Only Kent and Lars bid at prices between $4,000 and $4,200.
Douglas drops out of the auction because he’s not willing to pay more than $4,000.
3. Lars purchases the land at the first bid over $4,200.
After the price per acre exceeds $4,200, Kent drops out of the auction, leaving Lars as the only bidder. Thus, the minimum amount Lars must spend to purchase the land is $4,200.01.
The winner of the English auction generally has to bid just a little more than the individual who places the second highest value on the item.
Bidding first wins: The Dutch auction In a Dutch auction, the first bid wins. The bidding starts with the seller asking an extremely high price — a price nobody is willing to pay. The price is then gradually lowered until one buyer indicates a willingness to purchase the item. At that point, the auction is over and the item sold. In a Dutch auction, no information regarding other bidders’ preferences is available to potential buyers. Because the first bid is the winning bid, potential buyers can’t determine the item’s potential value to anyone else. As a result, to avoid losing the opportunity to purchase the item, buyers tend to bid the maximum amount they’re willing to pay.
As with the English auction in the last example, assume that 500 acres of farmland are being auctioned. Again, three individuals are willing to bid on the land — Oliver Wendell Douglas, John Kent, and Owen Lars. Douglas is willing to pay $4,000 per acre, Kent is willing to pay $4,200 per acre, and Lars is willing to pay $5,000 per acre. To determine who ultimately purchases the land in a Dutch auction and how much the individual pays, you take the following steps:
1. The auction starts at an extremely high price; perhaps $10,000 per acre.
The auctioneer sets the price so high that nobody is willing to purchase the land.
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