By Michael Abernethy
GETTING TO KNOW DUTCH AUCTIONS
What do you really know about a Dutch Auction? The history and origin of the Dutch Auction is actually a fascinating look at many of the same economic themes and issues we look at today. Microeconomic themes like supply and demand, finance themes like futures and options, and auction theory themes like first price and efficient pricing all were explored in 1600's Holland, hundreds of years before they were considered the science they are today.
Let's start by taking a look back historically at the origin of the Dutch Auction. It's the early 1600's in Holland, and the tulip bulb has recently been introduced to the country by traders from the Ottoman empire. The flower is unique and unlike any other flower in Europe at the time. It's tough to imagine in today's world where people are familiar with everything the world has to offer, but imagine seeing a bright purple dog for the first time. People would want it based simply on its uniqueness. The same instant demand occurred in the tulip market, and the people wanting to own the flower for themselves started to grow quickly. A demand curve that didn't exist initially suddenly appears and starts moving up quickly.
However, the botanical limitations of the tulip serve to constrain the supply curve. It takes 7-12 years to grow a tulip from a seed to its tradable asset, the bulb. And the most sought after bulbs, the multi-colored bulbs, would take even longer to grow. So with a quickly growing demand curve, and a relatively fixed supply curve with an extremely long production cycle, the possibility for a spike in prices is extremely high. To compare it to modern products, imagine if the demand for a time-intensive alcoholic beverage suddenly exploded in popularity. Take something like Johnnie Walker Black and assume that its popularity explodes 3x over the next year. Because Johnnie Walker takes 12 years to make, there's no possible way to meet the demand, and as a result the price starts to grow extremely quickly.
Let's throw a few more variables into this Dutch tulip market. The flower only blooms during April and May. During the Summer months, the flower returns into its bulb form, which means it can be dug up and moved around. The rest of the year, the tulip must be in dirt and doesn't show a flower. Essentially, the tulip can only be traded for 3 months a year, but the market and demand exist all year round. What resulted was the first modern futures contract - at any time during the year, tulip sellers and tulip buyers would sign a contract to deliver X amount of tulips on a given date in the Summer at price Y. Further, these contracts could be traded amongst other buyers and sellers to create a functional futures market. So, the futures market as we know it today is a direct result of the Dutch traders wanting to buy and sell tulips year-round despite being botanically limited to physically trading them and delivering them for only 3 months a year.
Finally, during the height of the Panic, the Dutch Parliament passed a law in an effort to curb the panic that stated that all futures contracts could be canceled at any point if the buyer paid the seller 3.5% of the contract price. A contract that can be canceled at any point with only a fixed price paid to the seller for the right to cancel - sounds an awful lot like an option to me! Yes, even the primitive option market was created during the Dutch Tulip Panic. As modern finance could predict however, with only a small penalty for misguided speculative bets, these new option contracts exacerbated the problem by allowing traders to increase their bets through massive leverage. Sometimes creating new financial instruments can lead to unintended negative consequences!
Back to the Dutch Auction. Now that you know the background of the tulip market, you can picture the crazy scene at the Exchange: traders milling around talking loudly, the noise, the hubbub, the contracts flying around. Total commotion, very noisy, and very hard to keep everything organized. The Exchange figured, correctly, that the best solution to selling the bulbs was to do it quickly, to do it with as few bids as possible, while at the same time getting as high a price as possible.
The solution, of course, was a Dutch Auction. A true Dutch Auction has the following attributes: it starts at an artificially high price, where demand is known (or believed) to be 0. At publicly known time intervals, the price ticks down in publicly known price increments. The price continues to tick down until the first bid is received. At this point, the auction ends immediately, and the bidder wins the product at the price when he placed his bid.
The benefits to the Exchange are obvious - only 1 bid needs to be placed, so by making the starting price relatively close to the predicted sales price and making the time intervals small, auctions can be completed extremely rapidly. The auction has economic benefits to the seller as well - in theory it results in a price equivalent to a sealed-bid auction (where each bidder submits bids in an envelope, and the high bidder wins at the price they bid).
Let's take a modern example and run it through a Dutch Auction. The seller is trying to sell a limited edition gold plated Mercedes SLS AMG. Very expensive item, but the exact price, and exact demand, for the item is unsure. A perfect candidate for an auction. The seller publicly states that the opening price will be $5,000,000 and will tick down by $100,000 every 5 minutes.
- The auction begins
- after 5 minutes, the price drops to $4.9M
- after 10 minutes, the price drops to $4.8M
- after 15 minutes, the price drops to $4.7M
- Finally, after 30 minutes, with the price at $4.4M, Bidder A raises their hand to place a bid.
- The auction ends immediately. Bidder A has just won the car at $4.4M.
Quick aside, this $4.4M is not the same economic results from an EBay auction. While EBay auctions might seem simple, they aren't the most economically advantageous for the seller. An EBay auction is a Second-Price Auction, while a Dutch Auction is a first-price equivalent. Assume in the above auction that Bidder B would have paid $4.1M for the car. In an EBay auction, Bidder A, who would have paid $4.4M, will now only pay $4.2M (second price + 1 increment). This is good news for Bidder A, who saves $200k, but bad news for the seller, who gets less money on their sale. Remember, since the seller is the one who almost always designs auctions, they should choose the format that's most advantageous economically for themselves.
To wrap everything up, this type of auction format which originated in the crazy times of the Dutch Tulip Craze took the name of the people who popularlized it and made it prevalent.
Simple Dutch Auction
- The seller recognizes their fullest economic benefits from the sale
- Descending prices ensure bidders will bid promptly when their internal price is reached
- Quick and simple to implement, easy to understand for bidders
- Everything is done out in the open, transparency to everyone involved
- The buyer pays their maximum internal price
- Cannot be done when bidders do not all have instant access to information (for example, someone bidding over the phone would be at a disadvantage due to the time-delay going through a bidding proxy)
- It only works when 1 product is being sold (If we wanted to sell 2 gold SLS AMG's at the same time, this Simple Dutch Auction format could not be used.)
In future posts, I'll discuss how to get around these limitations on a Simple Dutch Auction, and introduce you to other variations on the Dutch Auction, including the popular and powerful Second-Item Auction (also known as a Dutch Auction IPO or Google IPO Auction), a Supply/Demand Auction (where bidders and suppliers enter bids), and finally I will introduce you to Optimal Auctions' unique and powerful Dutch auction solution, our own Advanced Dutch Auction, which solves all the limitations in the Dutch auction varieties that are common today.