Adapted from “On the Block: Choose the Best Type of Auction,” by Guhan Subramanian (professor, Harvard Law School and Harvard Business School) and Richard Zeckhauser (professor, Harvard Kennedy School), first published in the Negotiation newsletter.
Most everyday auctions are English: they begin with an opening bid, continue with ascending bids, and end when the bidding stops. But for some assets, the seller opens at a very high price, then moves down rather than up if all bidders are silent. As soon as one bidder agrees to buy, the auction is over. Because the vast Amsterdam flower market uses this descending method, such auctions are called Dutch. Every week, the U.S. Treasury Department auctions off billions of dollars’ worth of Treasury bills in a written-bid Dutch auction in which all winners pay a market-clearing price.
In a departure from the usual rules of the game, Internet search engine Google’s long-awaited IPO was conducted in August 2004 via a type of Dutch auction. In a traditional IPO, a company announces the price at which shares will be offered; institutions and other investors then have the opportunity to buy shares at that price. Google, by contrast, auctioned off its shares to the highest bidders. Potential investors proposed buying a specific number of shares at a specific price. Based on these offers, Google calculated its clearing price—a price that would allow it to sell the shares it was offering to the public. All bidders who bid at or above the clearing price received shares at the clearing price, not at their bid price.
Much has been made of the fact that Google originally signaled a clearing price in the $108 to $135 range to potential investors yet ended up setting a price of $85. (This lower-than-expected price was vindicated somewhat by an 18% increase in Google’s share price on the first day of trading.) Google’s shaky experience with a Dutch auction may have had more to do with some of its process choices than with the mechanism itself. For example, Google warned investors against submitting multiple bids—bad advice. Not only would multiple bids reflect a buyer’s preferences better than a single bid, but encouraging multiple bids would have increased Google’s clearing price, to the company’s benefit.
The rarity of Dutch auctions can discourage bidders, but they can be useful in certain situations. Imagine you represent a pharmaceutical company that is committed to holding an open-bid auction for a patent on a new process. You strongly expect that Brent Corporation will be the highest bidder and that all other bids will be considerably lower, perhaps by 60%. The bidders are mostly in the dark about one another’s valuations. Consider what might happen if Brent valued the patent at $1 million. In an English auction, if the maximum valuation of any of Brent’s competitors was $600,000, Brent could acquire the patent for about $610,000. In a Dutch auction, however, Brent, unaware of its competitors’ valuations, might jump in to buy once the bid descended to $900,000, to reap a sure $100,000 surplus. When the valuations of the two highest bidders are far apart, a Dutch auction can secure a much higher price.
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Related Article: When Negotiation Trumps Procurement Auctions