The Auction Problem - YouTube

Vsauce!

Kevin here, and I’m auctioning off the ultra-rare PlayStation 5: Jake Roper “Prepare to Cry”

edition, which evokes the frustration and heartbreak of Jake’s fruitless attempts

at securing his very own PS5.

With this edition, you’re buying countless hours of entertainment -- and a monument to

one man’s pain.

I’m auctioning it using a system of sealed bids -- the bidders submit their price and

we determine a winner.

I’ve got 4 bids…

Ready?

Okay bid number one...

Hideo Kojima?

MY GREAT FRIEND HIDEO KOJIMA WHO I MET FOR 9 SECONDS IN 2013?

Even HE can’t get a PS5?

Alright well, $400, that’s pretty undervalued -- he must be a very patient and frugal man.

The PS5 retails for $499, so if this bid wins, Kojima is getting a serious deal.

Alright, bid #2: BALLOON KEVIN!?

You are not Real Kevin!

How many times?

I am Real Kevin.

How did you even get in here?

Well, Whatever.

And what is your bid? $3?

$3.

Okay.

Balloon Kevin is a scammer.

What a stupid bid.

But I guess maybe he thought lowballing was worth a shot.

Whatever.

Ugh.

Moving on...

Bid #3: Oh, this bid is actually from Jake himself, still desperately trying to get a

PS5. $550?

That, that’s fair.

It’s a 10% premium on top of the going price, which makes sense for something in such high

demand.

Smart bid -- good luck!

Hopefully we can dry those Roper tears.

And now to reveal the fourth and final bid.

Drumroll please...

$8,000!? WOW!

That is..

THAT is a serious bid.

Michael must really want this thing.

Well, SOLD!

For $8,000.

THAT is absolutely what you would call a..

Pro.

Gamer.

Move.

Dramatically outbidding everyone to secure the win, and here’s something that you don’t

realize is so genius about it.

This isn’t a normal auction.

No.

This is a Vickrey auction!

Which means the winner doesn’t pay the highest bid.

They pay the second highest bidder’s bid.

In this case, that’d be Jake’s $550.

Sorry Jake.

You’re really gonna wanna stay hydrated because those tears will continue to flow

as Michael is playing his brand new PS5 after only paying YOUR $550 bid.

So, that’s that!

And as always thanks for watching… w….wait…

A really aggressive bid worked out this time, yeah.

But overbidding on a Vickrey auction is actually a really, really bad idea -- and virtually

no one realizes that the most popular auction house in human history works this way.

Here’s a question: WHAT ARE AUCTIONS?

The discipline of auction theory within economics is built on a handful of basic auction formats.

You’re probably used to auctions that start low and people bid back and forth until there’s

only one bidder left.

The highest bid wins -- that’s an English auction, or an “open-bid ascending auction”

if you wanna get TECHNICAL.

You can also do auctions the other way, as well.

A Dutch auction starts at a price nobody would pay and descends until the first person bids

and thereby wins instantly.

And there are two types of sealed bid auctions.

In a normal sealed bid auction, everyone submits their secret bid and the highest one wins

-- the end.

Then there’s the Vickrey Auction, a sealed bid auction in which the highest bidder actually

pays the second-highest bid.

But why would you do it that way?!

Why not just keep it simple?

And how can such a tiny change in the rules even make a difference?

First, it’s important to note that we’re dealing with an item with known value.

There’s an established retail price for the PS5, so we’ve got a pretty good sense

of what it’s worth -- millions of people have paid that price.

Compare that to, say… a painting.

I might think it’s a $100 painting.

Painting Collector McGee, a person I just made up, might think it’s a $25,000 painting.

I don’t know.

But..

What about if the item is like an oil field somewhere and no one knows what’s really

under the ground.

That makes it tough to establish a value yourself, but it makes it really hard to know what other

people might be bidding.

With a PS5, we’ve got a pretty good idea of what other people might be thinking.

So let’s say Jake figured he’d be up against someone who might bid at least as much as

the $550 he was willing to pay… but maybe they’ll try to get a deal and hope that

everyone else can’t afford it.

He thinks they’ve got a bidding range of $450 to $650, with an equal probability of

submitting any bid within that range.

So should he bid $550, so half the time he wins, half the time he doesn’t, and when

he loses he’s not really out anything?

In a standard sealed bid auction format…

No.

If he bids over $550 and wins, he’s losing value by paying more than he wanted to, so

that’s out.

But if he bids under $550 -- say, $530 -- he’ll still win 40% of the time against the mystery

bidder, and each time he wins he’s saving $20.

If the highest bid was over $550, he would have lost anyway.

The extra value he gains out of saving $20 4 times out of ten outweighs that one time

he’d bid $530 and lose to a bid of $550.

That’s called ‘bid shading,’ and it’s what Nobel prize-winner William Vickrey solved

in 1961 in “Counterspeculation, Auctions, and Competitive Sealed Tenders.”

Vickrey’s work on auctions included the development of the Revenue Equivalence Theorem,

which showed that if an auction satisfies a handful of conditions, the revenue for the

seller will be the same no matter what the format -- and for all this, he found out he

won the 1996 Nobel Prize in Economics just 3 days before he died.

So what’s so great about Vickrey Auctions?

By making the winner pay the second-highest bid instead, that incentive to manipulate

the bidding evaporated -- and it actually started to pay to be as honest as possible.

Vickrey ushered in an era of honest bidding being the dominant strategy in an auction

-- let’s go back to Jake.

He wants to pay $550 for the PS5 because that’s what it’s worth to him.

If he commits to the pro gamer move of bidding $8,000 just to guarantee that he’ll win

the auction, the second highest bidder could be any number lower than that.

He could get stuck paying $600, $800, $4,000, or more, especially if someone else is trying

to use the same strategy.

Inflating his bid not only doesn’t help, but could put him in a really bad position.

If Jake wants to try to save a little money, he can still bid $550 -- because if he wins,

he’s paying less than that anyway based on whatever the next-highest bid is.

He doesn’t have to engage in bid shading… and if he does try to game the system, he’s

susceptible to being outbid and losing.

In a second-price auction, potential buyers also have a much harder time colluding with

each other to manipulate the price in their favor, and sellers just don’t have enough

information to successfully ‘plant’ bids to drive up a price.

In a Vickrey auction, Jake’s incentive to go higher or lower than his true value is

just… gone.

$550 is his best bid.

But it’s not just best for him: everyone he’s bidding against has the same incentive

to bid honestly, too.

The same forces are at work for them, and they know it, so why not just be honest?

The seller knows no one’s trying to game the system, either, and they’re gonna get

the best price for their item.

And guess what?

This is pretty much how eBay works.

Everyone submits their bid and the winner pays just a tiny bit more than the second-highest

bid.

Vickrey had no way to know that almost 60 years after his paper, one single website

on the internet would house nearly a billion and a half auctions for everyday items worldwide

-- and virtually everyone would be able to use his bidding system from a device in their

pockets.

The 2020 Nobel prize in Economics went to Robert B. Wilson and Paul Milgrom for their

work advancing auction theory -- and we’ve been thinking about a system where I have

something, you want it, and we need to figure out how to exchange it in a way that’s best

for both of us for a long time.

The Greek historian Herodotus wrote about Babylonian auctions in 2,500 BC, and that's

the most surprising thing here.

In 4,500 years of thinking about auctions, the mathematical development optimizing the

activity of billions of people is really close to just… being honest.

And in the spirit of honesty...

I’m actually not auctioning my PS5 because I have Demon’s Souls to play!

And as always -- thanks for watching.