A common example of this kind of auction is the Dutch wholesale flower auctions and treasury auctions by the United States Department of Treasury for all T-bills, notes, and bonds.
Bidding behavior in a Dutch auction depends on the reserve utility of the first bidder and his/her information about the probability of other bids. Reserve utility is his/her subjective valuation of the good being auctioned.
If he/she bids as soon as the price falls to his/her reserve utility, he/she maximizes the probability of winning the item, but minimizes his/her surplus, that is, the difference between the winning bid and his/ her reserve utility.
If he/she waits longer for prices to fall further, he/she increases his/ her surplus but reduces his/her probability of winning the item. Accordingly, other bidders will behave based on their expectation about the first bidder’s behavior.
Noble Laureate economist William Vickrey has shown that under a set of assumptions both the progressive price English auction and the regressive price Dutch auction results in the same average expected price and gains for the buyers and the sellers.
The variance of the price, however, is smaller for the Dutch auction by a factor of (N − 1)/2N than the English auction where N is the number of bidders. The variance of the gain by the winning bidder is smaller by a factor of 1/N2 in case of a Dutch auction. Hence, for risk-averse buyers and sellers, Dutch auction is slightly better than the English auction because of the smaller variance of gains.
Vickrey further argues that where bidders are fairly sophisticated and homogeneous, that is, they have similar information and bidding strategies, the Dutch auction may produce results that are close to Paretooptimal case of English auction.
The term “Pareto-optimal” suggests that an alternative allocation (than the existing one) where one bidder is better off without making at least one bidder worse off is not possible for the good being auctioned.
Where the bidders have different set of information or are less sophisticated, Dutch auction may produce higher price and lower average surplus for the buyers relative to the Paretooptimal English auction and can be relatively inefficient from the bidders’ point of view. Similarly, there are other extremes where Dutch auction produces lower price and may be inefficient from seller’s perspective.
Despite the complexity of the Dutch auction process and the optimization problem faced by the bidders due to the tradeoff between maximizing the surplus or gain from winning and the probability of winning the auction item, Vickrey argued and Milgrom further elaborated that the task of a bidder in a Dutch auction is similar to that of abidder in a sealed bid auction. In a sealed bid auction, the seller sells the goods to the highest bidder at his/her own bid.
Milgrom argues that in both cases the bidder’s choice is to determine the price at which he/she is willing to obtain the good. In case of a Dutch auction, the bidder starts with the highest price he/she is willing to bid. When price drops to that level, the bidder has the option to bid or to wait.
If he/she chooses to wait, he/she updates the highest price he/ she is willing to bid at that point based on the latest information. This process is repeated and can be summarized into a single price that the bidder is willing to pay. Hence, the Dutch auction and sealed bid auction should result in the same selling price.
In laboratory experiments where stakes are low, the above prediction does not hold. In these experiments, winning bidders in a Dutch auction on average pay a lower price than the sealed bid auction.
He postulates that the design of a Dutch auction discourages the bidders from advance planning and hence results in lower price. Other alternatives suggested by him are
- the bidders in these experiments are not maximizing utility, and
- the lower stakes in the experiments encourage bidders to wait longer before bidding.
The term “Dutch auction” used in connection with share repurchase or Initial Public Offering (IPO) share allocation has a different mechanism. Bagwell describes the Dutch auction method for share repurchase.
The buying firm in such auction specifies a range of prices at which shareholders can offer to sell their shares. Selling shareholders indicate the reserve price or the minimum selling price he/she is willing to accept and the quantity available at that price.
The buyer aggregates the supply quantity and constructs the supply curve. The lowest price at which the demand of the repurchasing firm is fulfilled is paid to all sellers who are willing to sell at this price or below.
Share repurchase with a Dutch auction pays lower premium (relative to the open market price) than a fixed price repurchase but the number of shares demanded is also lower in the former case. They also find that Dutch auctions are preferred by large firms that are transparent in terms of information.