Vickrey Auction – Meaning, Benefits, and Weaknesses

Vickrey Auction: Understanding the Term

Vickrey Auction is a type of sealed-bid auction. Like with any other sealed-bid auction, in this auction, also bidders submit the bids without knowing what the other bidders have bid for. Similarly, to what happens in other types of auctions, in this auction also, the highest bidder wins the auction. However, what price the winner pays is the second-highest bid and not the highest one or the bid winning price.

For example, A, B, and C bid for an item at $30, $40, and $50, respectively. In an ordinary auction, C will win and pay $50. In a Vickrey auction also, C will win but will pay $40 to get the item.

The objective of such an auction is to encourage the bidders to bid as per their maximum willingness. This is because they will, anyways, be paying the second-highest bid. Such an auction can be for a single item or multiple items. In 1961, Columbia University professor William Vickrey invented this auction. Prof Vickrey had been awarded the Nobel Prize for this work.

Vickrey Auction: Concept

For a better understanding of the concept let us discuss and explain this with one example.

Suppose Mr. A is selling an MP3 player with a collection of rare songs. And Mr. A invites the bidders to submit their bids in a sealed envelope. The MP3 player would go to the highest bidder in a regular auction.

Also Read: Auctions

What if the bidders feel that the MP3 player under auction is very valuable. However, each bidder does not know whether others also believe the same. So, in such a case, all bidders could bid much less (or more) than what they believe the MP3 player is worth. This is because every bidder will think that other bidders will value MP3 less (or more). 

If this holds, all the bidders will bid for less (or more) than what they actually believe the MP3 player is worth. Either way, the auction will not be efficient. And the seller carries the risk of getting a low bid price for the product.

vickrey auction

This is where the Vickrey auction can be helpful. In this auction, the MP3 player will go, of course, to the highest bidder. But it will be given to him at the price that the second bidder has bid. Thus, such an auction encourages the bidder to bid honestly. This is because the amount that a bidder bids only determines whether or not they win the auction. But, the amount that the bidder will pay will depend on the amount of the second-highest bid.

So, we can say that such an auction encourages the bidder to submit their maximum bid. This is because the bidder would know that they will pay or have to pay a lesser amount if they win the auction. 

Also Read: English Auction

If all the bidders realize this concept of the Vickrey auction, they will bid the amount they feel is the best value of the item under auction. And, no bidder will pay more than what they believe the item is worth. The seller also will get the maximum amount.

Or, we can also say that the bidder will not bid more than the maximum value they have established for the auction item. This is because they do not want to pay an amount more than their maximum willingness.

Similarly, they will not a submit a lower bid due to the chances of losing the item by bidding an amount that is less than their maximum willingness.

Benefits and Weaknesses of Vickrey Auction

Following are the benefits of this auction:

  • It lowers the chances of a bidder overpaying for an item under auction.
  • It raises the chances of the seller getting the most for their product.
  • This auction encourages bidders to bid for the maximum amount.
  • It helps the bid winner save some money.

Following are the weaknesses of this auction:

  • If all bidders secretly collaborate, they can lower their bids. In this case, the seller will not get the maximum amount.
  • Such an auction can also encourage shill bidding in case of an online auction. If a bidder has two accounts, then they can use one account to bid the highest in order to raise their chances of winning. And, using the other account, they can minimize the price (to be at the second position) so that they pay less.
  • If the bidders are not sure about their own valuation of the auction item, then such an auction may not help in price discovery.

Final Words

Vickrey Auction is a smart way to make an auction efficient. It motivates the participants to bid the maximum amount willingly. Moreover, such an auction raises the chances of the seller getting the true worth of their item. However, such a type of auction is very rare.

Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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