At an auction with many bidders, it is generally believed that bidders will behave competitively. It is assumed that competition is the best way to maximize the price received. Now, research by Jin Li, an assistant professor of management and strategy at the Kellogg School of Management, has shown that in some circumstances, bidders engage in collusive strategies that enable them to get a bargain price—perhaps a price even lower than what the item is worth.
Li says that even when bidders do not verbally communicate, they may be able to use information about each other to coordinate mutually beneficial strategies. Li explains, “I may know that you like item A more and I like item B more. I don’t want to compete head-to-head with you on the item you want, and you don’t want to compete head-to-head with me on the item I want. So I’m going to just bid $1 or even $0 on item A and let you win. Conversely, you are going to bid $1 or $0 on item B and let me win.”
Such a strategy may already have been used in the high-stakes Federal Communications Commissions (FCC) spectrum auctions. Since 1994 the FCC has auctioned licenses to companies that want to broadcast on the electromagnetic spectrum. According to the FCC, auctions have dropped the average time from initial application to license grant to less than one year. The public, they say, is now receiving the direct financial benefit from the award of licenses. But Li notes that if firms tacitly collude during these auctions by bidding on the licenses they want the most and not bidding on the others, then auctions will generate very little money for the government. Indeed, The Economist reported that in one set of FCC auctions a company won four separate licenses for just $1 each. “The value of these options is clearly more than that,” Li says.
Even so, tacit collusion among several agents has not been convincingly documented in a natural setting, and it has not been produced in an experimental setting in the absence of a conspiracy or other facilitating condition. Furthermore, although economic theories suggest that tacit collusion can arise, they also suggest that many other outcomes, including competitive bidding, may result. Little is known about the conditions under which collusion is more likely to arise.
The “Collusion Incubator”
To determine how tacit collusion arises in auctions and how to stop it, Li worked with Charles Plott of the California Institute of Technology to create an experimental environment that functioned as a “collusion incubator.” Each experiment had eight subjects, numbered anonymously, who bid on eight items. The bidding took place simultaneously. Each subject was assigned valuations for each item, ranging from 50 to 900 francs, with the reservation price of 100 francs each. After the experiment each franc could be exchanged for one cent. The key feature of the experiment was that every bidder had a favorite item, and no two bidders shared the same favorite item. To facilitate comparisons, the valuations were kept identical across experiments, but within each experiment, the valuations differed from round to round. The subject’s payoff or loss was calculated as the difference between the items’ valuations and the winning bid price. If the subject won an item below its valuation, they profited. Conversely, if the winning price exceeded the valuation, they incurred a loss. Li and Plott knew tacit collusion had arisen if every item was sold at the reservation price (100 francs).
In the initial stages of the experiments, the subjects had extensive knowledge about their situation, including the valuation of each item assigned to each subject and who had bid what price on which item. In most cases, the participants did not know what the total number of rounds would be.
Li and Plott found that subjects started with different views about how to play the game. “Some bidders immediately figured out that they would like to collude, that they could make the most money that way,” Li says. “Other bidders didn’t realize that. They started out bidding very competitively. However, eventually they turned to tacit collusion.”
Once tacit collusion was reached, the average price paid per item went down (Figure 1), the number of bids decreased, and the auction duration shortened. “If people collude with each other, then they make a lot more money. So eventually people will figure out the equilibrium that maximizes their payoff,” Li says. In their paper published in Economic Inquiry, he and Plott report that tacit collusion evolved naturally, “without conspiracy and without intervention or encouragement by the experimenter and without any special facilitating device.”
A Winding Road
How bidders arrive at tacit collusion can be complicated. In some experiments, it is reached quickly. In other experiments, the road toward tacit collusion is more arduous. For example, in one of the experiments a price war broke out between a “collusive” subject and one who had not yet adopted a collusive strategy. During the price war, the collusive subject bid on an item at a price that exceeded his own valuation. Li explains that this behavior was used to send a message to the subject who was not cooperating. “The competitive bidder observes the seemingly irrational behavior of the bidder who instigates the price war, behavior that seems to be against his own self-interest, and thinks, ‘That is really weird, no one should be doing that,’ ” Li says. “However, it eventually serves as a message that there could be better ways to play the game—other strategies that the bidders can use. So eventually everyone will transition into tacit collusion.” And that is exactly what happened in the experiment. In the round after the price war, the previously competitive subject adopted a collusive strategy.
After tacit collusion was established in each experiment, Plott and Li created a “competition-conducive environment” in order to study the stability of tacit collusion (see Table 1 for the modifications that were used to try to disrupt the collusive bidding). They added a surprise competitive entry that was somewhat effective—it made convergence back toward collusive equilibrium difficult. But in general, tacit collusion remained entrenched. “In the natural world, once these firms start to figure out how to play the game—that is, how to tacitly collude—it’s very hard to break,” Li says. He and Plott write that tacit collusion “appears to be held in place by a pure system of belief as opposed to institutions and information that enable the maintenance of a Perfect Bayesian Equilibrium.”
Li notes that in a follow-up experiment, Plott and colleagues discovered that the tacit collusion established in the collusion incubator could be broken using the “Dutch auction,” a format used in the Netherlands for selling flowers. In this system, the price goes down instead of up as the bidding proceeds. The auction ends whenever someone says, “I want it at this price.”
“In designing auctions, people should be very careful about collusion,” Li concludes. “Institutional design is very important to human behavior.”
Further Reading
Brown, Alexander L., Charles R. Plott, and Heidi J. Sullivan. 2009. “Collusion facilitating and collusion breaking power of simultaneous ascending and descending price auctions.” Economic Inquiry, 47(3): 395–424.
Li, Jin and Charles R. Plott. 2009. “Tacit collusion in auctions and conditions for its facilitation and prevention: equilibrium selection in laboratory experimental markets.” Economic Inquiry. 47(3): 425-448.
-
What Went Wrong at Silicon Valley Bank?And how can it be avoided next time? A new analysis sheds light on vulnerabilities within the U.S. banking industry.
-
How Are Black–White Biracial People Perceived in Terms of Race?Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
-
What Went Wrong at AIG?Unpacking the insurance giant's collapse during the 2008 financial crisis.
-
Will AI Eventually Replace Doctors?Maybe not entirely. But the doctor–patient relationship is likely to change dramatically.
-
Which Form of Government Is Best?Democracies may not outlast dictatorships, but they adapt better.
-
Podcast: "It's Hard to Regulate U.S. Banks!"Silicon Valley Bank spectacularly collapsed—and a new analysis suggests that its precarious situation is not as much of an outlier as we’d hope. On this episode of The Insightful Leader, we learn what went wrong and what should happen next.
-
What Happens to Worker Productivity after a Minimum Wage Increase?A pay raise boosts productivity for some—but the impact on the bottom line is more complicated.
-
Why Do Some People Succeed after Failing, While Others Continue to Flounder?A new study dispels some of the mystery behind success after failure.
-
Marketers, Don’t Be Too Hasty to Act on DataDon’t like the trends you’re seeing? It’s tempting to take immediate action. Instead, consider a hypothesis-driven approach to solving your problems.
-
Why Well-Meaning NGOs Sometimes Do More Harm than GoodStudies of aid groups in Ghana and Uganda show why it’s so important to coordinate with local governments and institutions.
-
Understanding the Pandemic’s Lasting Impact on Real EstateWork-from-home has stuck around. What does this mean for residential and commercial real-estate markets?
-
How Has Marketing Changed over the Past Half-Century?Phil Kotler’s groundbreaking textbook came out 55 years ago. Sixteen editions later, he and coauthor Alexander Chernev discuss how big data, social media, and purpose-driven branding are moving the field forward.
-
How Peer Pressure Can Lead Teens to Underachieve—Even in Schools Where It’s “Cool to Be Smart”New research offers lessons for administrators hoping to improve student performance.
-
How Much Do Campaign Ads Matter?Tone is key, according to new research, which found that a change in TV ad strategy could have altered the results of the 2000 presidential election.
-
Immigrants to the U.S. Create More Jobs than They TakeA new study finds that immigrants are far more likely to found companies—both large and small—than native-born Americans.
-
Leaders, Don’t Be Afraid to Admit Your FlawsWe prefer to work for people who can make themselves vulnerable, a new study finds. But there are limits.
-
For Students with Disabilities, Discrimination Starts Before They Even Enter SchoolPublic-school principals are less welcoming to prospective families with disabled children—particularly when they’re Black.
-
Executive Presence Isn’t One-Size-Fits-All. Here’s How to Develop Yours.A professor and executive coach unpacks this seemingly elusive trait.
-
How Self-Reflection Can Make You a Better LeaderSetting aside 15 minutes a day can help you prioritize, prepare, and build a stronger team