Underpricing and Market Power in Uniform Price Auctions

Ilan Kremer, Kjell G. Nyborg
2003 The Review of financial studies  
Underpricing and Market Power in Uniform Price Auctions In uniform auctions, buyers choose demand schedules as strategies and pay the same \market clearing" price for units awarded. The extant theory shows that these auctions are susceptible to arbitrarily large underpricing as a result of bidders having market power. This paper studies modi¯cations to the theory of common value uniform price auctions which make it more realistic and are of empirical or normative interest. Underpricing is shown
more » ... to be less severe than previously suggested and some empirical implications are developed. Uniform price auctions are widely used in¯nancial and commodity markets to sell many identical securities or goods simultaneously to multiple buyers. Examples include UK and US Treasury auctions. 1 In these auctions, bidders compete by simultaneously submitting collections of bids, or demand schedules, and the auctioned objects are allocated in the order of descending price until supply is exhausted. All bidders pay the same price { the stop-out price { which is the price of the lowest winning bid. Demand above the stop-out price is awarded in full, while marginal demand at the stop-out price is prorated. Uniform auctions thus work much like textbook Walrasian markets, with the notable exception that demand schedules are strategic. The theory of uniform auctions shows that they are susceptible to arbitrarily large underpricing. This is a result of market power which arises endogenously in equilibrium [Wilson (1979) , Back and Zender (1993) ]. However, in this paper we¯rst show that this underpricing can be reduced or even eliminated by breaking supply up into individual units. This is important because it corresponds to what is usually done in practice. It may help shed light on the prevalence of uniform auctions despite the theoretical warnings of severe underpricing. We also show that underpricing can be further reduced or eliminated by modifying the allocation rule. Thus from a normative perspective, our results show that the micro-design of a uniform price auction can dramatically improve performance. The model we examine is based on Wilson (1979) and Back and Zender (1993) . A possibly random amount is put up for sale, and risk neutral bidders choose demand schedules as strategies. The per unit expected value of the auctioned assets is a constant, v, and bidders share the same information set. 2 Despite the absence of private information, the model is very rich. The benchmark, competitive equilibrium, is that all bidders demand as much as they can at a price of v. However, Wilson and Back and Zender show that it is also equilibrium for bidders to submit downward sloping demand schedules which results in underpricing, that is, a stop-out price below v. In these equilibria, each bidder faces an upward sloping residual supply curve over which he is a monopsonist. So in equilibrium, the bidders are essentially in a sort of \complicit agreement" to give each other market power and thereby create underpricing. 3 In Section 3 we introduce quantity discreteness in the Wilson/Back and Zender model. We¯rst ask what happens if bidders can submit only a¯nite number of bids. Mathematically, this means that demand schedules are left continuous monotonically decreasing
doi:10.1093/rfs/hhg051 fatcat:jqmxowsavfawrbt2ycevmbrgti