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How To Set Reserve Prices In Auctions

For anyone selling something on eBay or even at Sotheby”s, new research suggests how to set a reserve price – a minimum price that must be met before the auction can be won – and whether or not to keep it secret.

Based on psychological insights, Professors Stephanie Rosenkranz and Patrick Schmitz challenge the traditional economic analysis of optimal reserve prices. Their study, published in the April 2007 Economic Journal, suggests that:

  • Sellers should keep the reserve price secret when exogenous reference prices (such as selling prices in auctions of related items or estimates delivered by auction house experts) are high.
  • Sellers should prefer second-price auctions (where the winning bidder pays the second-highest bid) over first-price auctions (where the winner pays his or her own bid) provided they keep the reserve price secret.
  • Sellers should set higher reserve prices when objects are auctioned to many potential bidders. Although intuitive, this is in stark contrast to traditional economic theory.

By placing a reserve price in an auction, the seller has, in essence, placed a bid against every other potential bidder. Why would you want to include a reserve price in the first place, and why would you want to keep it secret?

At first sight, questions like this may look merely theoretical, but not if you consider that more than 724,000 people in the United States make most or all of their income through eBay auctions, and another 1.5 million individuals say they supplement their income by selling on eBay (according to a Nielsen survey).

The first question, why a reserve price should be set, has been answered by traditional auction theory: in expectation that the selling price should be higher if a reserve price is set. But until now, economic theory could not provide a satisfactory answer for the second question, as it should not make any difference whether the reserve price is publicly announced or secret.

This study belongs to the emerging research field of ”behavioural economics”, which draws on insights from psychology to make economic analysis more realistic.

Rosenkranz and Schmitz comment: ”In the real world, a bidder”s willingness-to-pay does not only depend on his or
her intrinsic valuation of the object to be auctioned off, but also on psychological reference points: We all seem to constantly draw comparisons that determine our valuation and thus our willingness-to-pay.”

”Major auction houses such as Sotheby”s and Christie”s surely know this! They often include secret reserve prices in combination with public expert estimates. In the light of our study, their practice seems to be in fact not only in their own but also in their sellers” interests.”

A publicly announced reserve price is one of many factors that can determine a bidder”s reference point. After all, if there hadn”t been other bidders, the object would have changed hands for the minimum bid, and it just does not feel so good to pay much more than this reserve price.

The new study reveals that even if the impact of the reserve price on the bidders’ reference point is very small, taking care of the psychological effect has significant consequences for the optimal reserve price: if there is enough competition for the object (say, more than 30 bidders), the study shows that even if a reference point determines
a bidder’s willingness-to-pay for an object by only 1% (so that the bidder’s intrinsic valuation determines 99%) it may be optimal to increase the reserve price by 50% over and above what traditional economic models recommend. Moreover, the more potential bidders, the higher should be the reserve price, when taking the ”reference point effect” into account.

The bidders’ psychological reference point will also depend on factors that the seller cannot influence, for example, selling prices in auctions of related items or estimates delivered by auction house experts. If these factors imply a high reference point, then the seller should keep the reserve price secret, because a public reserve price could
only reduce the bidders’ reference point. The psychological reference point effect implies that the higher the reference point the more are potential buyers willing to pay. When the reserve price is kept secret, the seller”s expected revenue is larger if he or she uses a second-price instead of a first-price auction, which is in contrast to results obtained in traditional studies that ignore the psychological importance of reference points. When the reserve price is public, then the seller”s expected revenue is the same in first-price and second-price auctions, which is in accordance with traditional auction theory.

”Reserve Prices in Auctions as Reference Points” by Stephanie Rosenkranz and Patrick Schmitz is published in the April 2007 issue of the Economic Journal.

Stephanie Rosenkranz

S.Rosenkranz@uu.nl

Patrick Schmitz

University of Cologne