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An All-Pay Auction—A Commentary by Ian Ayres ’86

The following commentary was published in The New York Times on December 16, 2008.

An All-Pay Auction
By Ian Ayres ’86

Martin Shubik invented a famous game-theory exercise, sometimes called “the dollar auction,” where a teacher auctions off a $20 bill to the highest bidder. Bids have to be in round dollar amounts, but the twist is that both the highest and the second-highest bidder have to pay. When uninitiated students start to play this game, someone rushes to bid $3 or $4 dollars for the prospect of winning $20, and then other students respond by bidding up the price.

But then something amazing happens as the auction price starts approaching $20. The remaining bidders realize that they could end up having to pay a lot of money and not win the auction. Imagine that you had bid $19, and another bidder upped the ante by bidding $20. What would you do? Is it better to bid $21 for a $20 prize or to remain silent and pay $19 for nothing?

What starts off as a feel-good exercise to take advantage of a generous professorial offer suddenly becomes a sickening war of attrition, where the last two bidders pay more than what the prize is worth. These games routinely end with the winning bid being 50 percent higher than the value of the prize. Since both the highest and second-highest bidders pay, this means that the professor rakes in about three times the amount being auctioned.

This is an example of what auction theorists call an “all-pay” auction, and it’s a game you want to avoid playing if you possibly can.

But Barry Nalebuff pointed me toward a scary website — called swoopo.com — that seems to be exploiting the low-price allure of all-pay auctions. And it seems to be working.

Swoopo auctions off desirable (gotta have) electronic items (Wii’s, smartphones) for really low prices and with really short fuses — often less than a minute before the auction expires. It’s kind of seductive to watch these fast-paced auctions — because if someone ups the high bid, 15 seconds of extra time is added to the auction length. I found myself waiting to see if a TomTom GPS device would really end up selling for $18.

But there is an important hitch: you have to pay Swoopo $1 every time you bid. This creates an analogous all-pay effect. Swoopo may only sell a Wii for $30, but it might collect an extra $1,000 from bids. This website is a great experiment to see whether sunk costs matter. I’m thinking that someone who has already invested $5 in bidding costs is more likely to keep bidding to “protect” his or her sunk investments.

Of course, there is also the concern that you might end up competing against a Swoopo-bot that outbids you just before the time is about to expire. This is a game that I don’t want to start playing.