Airlines are using ever more sophisticated pricing strategies, sports teams and theaters are adopting dynamic pricing, even restaurants are using auctions to allocate scarce seating space. And the usual perception of this is that the consumer is being gouged. Auctions leverage competition among buyers and this drives the price up. Sellers are raising profits by eroding consumer surplus.
But as a counterpoint to this, here is a mostly unnoticed but fundamental principle of auction-like pricing schemes: they lead to unambiguously lower prices at the margin even when, indeed especially when, the seller is a coldhearted profit maximizer.
Suppose a theater allocates seats by selling tickets. And suppose they do it the old-fashined way: they set a price for tickets and put them up for sale until they sell out. Setting the right ticket price is a tricky problem because a price is a one-dimensional instrument that has to solve a two-sided problem. On the one hand, you want high prices in order to capture revenue when demand turns out to be strong. But on the other hand, you want low prices in order to ensure the theater isn’t empty when demand is weak. A price is simply too limited an instrument to do that double duty. It’s no wonder that there are so many empty seats on most days while on other days the show sells out way in advance.
An auction (or dynamic pricing or many other pricing systems) has built into it two separate mechanisms for handling those two separate problems. First there is the mechanism that leverages competition. When demand is strong buyers must compete with one another for limited space. When that happens the price is being set not by the seller but by the buyers themselves. A buyer wins a seat only if he is prepared to pay a price larger than the next most aggressive bidder.
The unsung virtue of the competition-leveraging aspect of auctions is that it relieves the other mechanism in an auction, the seller’s (reserve) price, of the burden of capturing revenue at the high-end of the market and allows the seller to use it for a single purpose: to capture revenue when demand is low. And this necessarily leads the seller to reduce his reserve price below the price he would have set if he were just using prices and not auctions.
The reason follows from a simple marginal trade-off. Think of what happens to the seller’s profit when he lowers his price a little. There are gains and losses. The gain is that the lower price leads to greater tickets sales when demand turns out to be low. The loss is that when demand is already high enough to sell out at the original price he will sell the same number of tickets but at a lower price. The seller’s optimal price is chosen to balance these gains and losses.
But with an auction the trade-off changes because the reserve price plays no role in determining revenues when demand is high. That’s when the buyers are setting their own prices. Cutting reserve prices leads to all the same gains but strictly lower losses compared to cutting plain-old prices.
The upshot of this is that the winners and losers from an auction system aren’t who you think. Auctions don’t favor the deep-pocketed compared to the small guys. Exactly the opposite. The marginal consumer is priced out of the market when a seller eschews an auction because then he must keep prices high. When a seller switches to an auction he lowers his reserve price and now the marginal consumer has a chance to buy at those low prices.
Helpful conversation with Toomas Hinnosaar acknowledged.