Realizing The Market Potential
In many markets much potential remains untapped because the right buyers and sellers never meet or negotiations fail. A fundamental challenge is to ensure that buyers with high willingness to pay meet sellers with low willingness to accept – and that they settle fair prices. Market design provides the structure and the trading rules that ease this valuable matching and pricing across individuals, firms and borders. The success of carefully organized auctions or exchange markets results from the gains of better matching and pricing across markets.
In the matching of buyers and sellers, it is crucial but time consuming to ensure timely supply or demand of the right quantity and quality of the right commodity. With traditional bilateral negotiations, the cost of searching and matching limits the number of matches one can try. With central coordination, a single system has contact to all sellers and buyers. Thus, more matches can be tried at lower cost – ideally, all possible matches can be attempted.
In many markets list prices do not exist, nor are prices negotiable. Therefore, for each match of a buyer and seller, a price has to be settled. Negotiating the price is difficult and time consuming and limits the number of matches that can be tried. With central coordination, a fair pricing may be done automatically at low cost.
The economic discipline on how to design the tools that make markets reach their potential
Market Design provides the structure that makes a market function better. The design of auction mechanisms, auction rules, is at the core of market design. The application of auctions has a very long history but the theory of auctions is rather new and has developed along with the discipline of information economics. An auction may improve the allocation of goods and services, e.g. by introducing apricing mechanism that leads to more profitable trading, by concentrating the market, or by making the market more transparent.
The central difficulty in designing auctions is that of private (confidential and decentralized) information. The bidders have private information, e.g. about their preferences or production costs. This information is needed – directly or indirectly – to determine an optimal allocation.
On the other hand, economic agents cannot be trusted to reveal their private information unless they are given the right incentives to do so. There are at least two reasons why direct or indirect revelation cannot be accomplished for free. First, the agents may try to act strategically to influence the auction outcome in their own favor. By taking advantage of their information they might possibly get a better share of the reallocation gains. Secondly, even if strategic manipulations do not pay in the auction, e.g. because each agent is sufficiently small to have any significant impact, the agents may still be reluctant to reveal their private information since they may fear that it can be misused in later or parallel markets.
Farmers, for example, may not trust a monopsonist processor to run an auction to reallocate production contracts since they may fear that the processor will be able to learn the marginal costs of the individual farmers and use this in subsequent negotiations.
Direct revelation mechanisms
An important group of auctions provide incentives to reveal truthful information. They are typically called direct revelation mechanisms. A central result in mechanism design states that for any mechanism there exists a direct revelation mechanism to which the participants tell the truth, that yields the same result.
The idea of this so-called revelation principle is that an impartial mediator or social planner uses the revealed information in the best interest of the parties. To avoid that the parties would be better off giving false information, the planner must restrict the way he uses the information – and he must be able to commit to this restricted usage.
In many cases, this is neither trivially nor cheaply accomplished. A mediator may be tempted or bribed to misuse the information he acquires in pursuit of his own or a specific bidder’s particular interests. The lack of a trusted impartial “planner” – or a trusted third party – that can compute the optimal outcome, is hereby a major obstacle in practical mechanism design. Solving this central issue is a primary concern of the Partisia Market Design solutions.
The actual choice of market design depends on the particular economic context. In the context of private information, the task is to set up rules that provide the market participants with proper incentives to allocate the goods or services in the most efficient way in the particular context. Hereby the focus is on maximizing the private and public gains from trade.
In practice, the choice of sophisticated market design will be bounded by the involved cost of implementing, using and administrating the market. To summarize, the choice of market design must solve three problems:
- Ensure that the market provides enough structure to solve the allocation problem
- Ensure that the market participants have the right incentives to solve the allocation problem
- Ensure minimal administrative costs and costs of using the market for the participant
The starting point of Partisia Market Design is to provide market designs (in particular auctions and exchanges) that best meet these objectives. Our primary product is software that implements and administrates such auctions at any desired level of confidentiality.
Partisia software solutions prevent some type of collusion and limit others
Colusion in auctions can be divided into two types:
- Type 1: Collusion that involves the central auctioneer directly.
- Type 2: Collusion that is coordinated by some or all of the participants outside the central auctioneer.
The risk of Type 2 collusion is most imminent in open auctions. When the bidding is organized as an open process, it is easier to sustain a cartel or to signal market partition during the bidding. In the auctioning of the 3G licenses in Germany, for example, two of the main competitors Mannesman and T-mobil managed to signal a market partition during the auction to avoid competing. Although, the open price formation is useful to facilitate price discovery, concerns about collusion and the protection of the participants’ private information are sufficiently important in many cases to oblige the use of partly or entirely sealed bids instead. In fact, OECD recommends sealed bids to prevent collusion in public procurement.
With partly or entirely sealed bids, a trusted third party is necessary. This creates a risk of Type 1 collusion. To illustrate with two cases, Siemens AG gained by getting confidential information about competitors’ bids in a public procurement in Singapore and Hochtief placed an optimal winning bid for the construction of a new airport in Berlin based on confidential information. Although collusion may be hard to prove in court, there are many cases and an attempt to estimate the costs has been done by the World Bank. In 2000 the estimated cost of bribing in procurement auctions was 12 % of the turnover and in 2004 the cost of corruption in public procurement alone was estimated at $200 billion. Also, the widely used proxy-bidding is a source of Type 1 collusion. In proxy bidding, a bidder places a maximal price and allows the “computer” to automatically overbid others until the maximal bid is reached. Knowing such a maximal bid can be valuable to the seller and others that gain from a high sales price.
Partisia can avoid collusion of Type 1:
With Partisia software solutions, the sealed bids are not available to any individuals or institutions. Therefore, this information cannot be misused to manipulate the price. The sealed bids can only be opened if one manages to collude with multiple persons key custodians across selected institutions. The number of key custodians required to unseal the bids can be customized. Hereby, collusion of Type 1 can effectively be avoided.
Partisia can limit collusion of Type 2:
It is harder to avoiding collusion of Type 2. While sealed bidding makes it difficult, Partisia software solution limits collusion of Type 2 even further. With encrypted bids no one can tell an empty bid from a carefully placed bid. Hereby, the software solution allows “pseudo participation” which makes it possible to hide a low real participation. E.g. in a procurement situation where a buyer faces the same class of sellers in successive auctions, pseudo participation may easily be implemented by a rule of compulsory participation among the class of sellers in order to qualify for future auctions. The higher participation significantly hamper collusion of Type 2.
Why deep confidentiality is important in Market Design
While a central coordinated auction or exchange is of great value, the potential leakages of private information may be costly. The traditional approach is to appoint well-reputed and trusted institutions or individuals to safeguard the private information. Still, individuals are granted full access to the information, an approach that is not only prone for human mistake but also provides a focal point for collusive behavior. With Partisia software no such focal point exists and the private bids are kept encrypted forever – this is what we call deep confidentiality.
On this page we discuss some reasons for having deep confidentiality:
- Keep positions in related negotiations
- Avoid aggregation of private values
- Basic reluctance to share private information
Keeping positions in related negotiations
The private bids in an auction or exchange may contain information that can be used by opponents in related negotiations or by authorities in a regulatory setting.An example is provided in the Danish Sugar industry, which uses Partisia Contract Exchange to reallocate production contracts among sugar beet growers. The contracts are regularly renegotiated among multiple types of growers and the sugar-processing company Danisco. Since the bids and asks on the exchange provide valuable information about the growers’ willingness to pay or accept, insufficient confidentiality may weaken the growers’ positions in these negotiations.
Another example could be procurement auctions. Sellers often have multiple contracts with the buyer, say a municipality, and the terms of these contracts are gradually adjusted. To impact this ongoing adjustment, a seller may therefore manipulate his bids on new contracts.
With deep confidentiality the participant does not weaken his or her position in related situations, no matter how the future is going to turn out.
Avoid aggregation of private values
Aggregation of private bids across time and auctions can generate valuable information about the participants’ preferences. Such information may for example be used to exercise more price discrimination at the cost of the participants.Computerized trading agents have been used for decades not least in the financial sector. Today, many Internet auctions, such as E-bay, provide so-called proxy bidding, where e.g. a buyer provides a price ceiling and allows a computer to overbid others within that ceiling.
It is extremely important to safeguard the private information feed to such trading agents. This was early acknowledged by Professor Hal Varian:
“Hence privacy appears to be a critical problem for ‘computerized purchasing agents’. This consideration usually does not arise with purely human participants, since it is generally thought that they can keep their private values secret. Even if current information can be safeguarded, records of past behavior can be extremely valuable, since historical data can be used to estimate willingness to pay. What should be the technological and social safeguards to deal with this problem?”
Since the date of this quote (1995), the concern has only increased. The use of auctions in general as well as more advanced auctions has increased. Advanced auctions may include multiple commodities or multiple attributes and extract more information from the participants.
Deep confidentiality effectively eliminates these problems since non-winning bids remain secret forever.
Basic reluctance to share private information
Apart from explicit, rational arguments, there might be a general reluctance to share private information.Private information revelation is a point of no return and it may be hard to foresee future use/misuse of the revealed information. This provides an implicit rationale for the basic reluctance. There may also be more subtle psychological reasons behind a basic reluctance.
With deep confidentiality any reluctance to participate with the required private information is removed and better results are promoted.