The Efficiency of Auctions

A Globe and Mail article describing the auction processed used to sell houses in Australia distracted us from our holiday celebrations and hockey tournaments. The article argues that an auction drives prices higher than the ask-offer system commonly used in North America. (Click here for article)


Markets are most efficient when there is a large number of both buyers and sellers all dealing with a homogeneous product. This is typically not true in real estate. Properties are heterogeneous; there is only one seller and multiple buyers. There is also an asymmetric information problem in that the seller knows everything that is wrong with the property and the potential buyer doesn’t. In the North American system, the seller offers the property for sale at a price that is higher than the minimum price they will accept. The potential buyers make offers below the maximum price that they are willing to pay.

Then comes the game. The seller wants to get the highest price that any of the potential buyers would be willing to pay. The seller responds to one of the offers by changing their terms, letting all potential buyers know that there are multiple offers. None of the buyers knows the terms of the other offers. If the sellers can’t come to suitable terms with the first potential buyer, they are free to negotiate with another. Typically, the seller will settle for a price that is less than their initial asking price, and above the initial offer. More importantly, the price will likely be below the highest price that a potential buyer would have been willing to pay. The seller’s agent is supposed to help get the highest price, the buyer’s agent is supposed to help get the lowest possible price. A seller’s agent is considered successful if the property is sold, not if it sold for the maximum price. The marginal benefit to the seller’s agent of getting an extra $1000 for the seller is less than the marginal cost of getting that $1000 and there is no benefit to the buyer’s agent attaining a $1,000 reduction in price. This process is inefficient for both seller and buyer.

An auction works differently. The seller sets a reservation price and multiple buyers bid against each other. The auctioneer is the seller’s agent and works to get the best price possible. As the price rises, potential buyers drop out until two are left. The winning bid will be just above the maximum price of the buyer with the second highest willingness to pay, but below the maximum price that the winning bidder was willing to pay.

The article suggests that the auction process is responsible for the rising prices in the Australian market. People don’t like to lose and therefore bid up prices in a frenzy. This argument requires that bidders behave irrationally on average. We normally assume that individuals maximize utility, or personal welfare. That implies that they know the maximum price that they are willing and able to pay and that rational individuals will not go above this price. An auction increases the price and benefit to the seller, whereas the bid-offer system does not.