Behaving badly with a flat salary

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.

283

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.

284 Part IV: Anticipating Surprises: Risk and Uncertainty

2. The auctioneer progressively lowers price.

As long as the price remains higher than the price anyone is willing to pay, no one bids. However, potential buyers don’t know anything about other bidders’ preferences. Therefore, potential buyers start getting nervous about losing the opportunity to buy the land as the auction price is lowered toward the price they’re willing to pay.

3. The price is lowered to $5,000 and Lars purchases the land by making the first and only bid.

Because Lars knows nothing about the other bidders’ preferences, he bids as soon as the land hits the price he’s willing to pay. Because the first bid is both the only bid and the winning bid, at this point the auction is over.

Dutch auction winners tend to bid the maximum amount they’re willing to pay.

In comparing the English auction to the Dutch auction, you should note that the winning bidder remains the same — Lars in the examples. However, in the English auction, Lars winning bid was only $4,200.01, while in the Dutch auction his winning bid was $5,000.

Sealing the deal: The sealed-bid auction

In a first-price, sealed-bid auction, potential buyers submit written bids without knowing what anyone else is bidding. The auctioneer collects the bids and sells the item to the highest bidder.

In both an English auction and a sealed-bid auction, the item is sold to the highest bidder. However, in a sealed-bid auction, potential buyers don’t know anything about the amount others are willing to bid. There is no bidding back-and-forth. As a result, bidders tend to bid the maximum amount they’re willing to pay with the result being similar to a Dutch auction.

Whenever risk is present, even the risk of not buying an item you want at an auction, you can’t be sure of the outcome. This risk can be very stressful. So, if you want to further reduce stress, you can always follow humorist Frank McKinney Hubbard’s advice, “The safe way to double your money is to fold it over once and put it in your pocket.”