High bids and broke winners (Q5952426)

The author considers a first-price sealed-bid auction game without a reserve price. A seller is to auction off an indivisible good to one of \(n\) competing bidders. Each bidder has his own budget. If the bidder makes a payment \(p\), then his cost is equal to \(p\) plus a cost of outside financing, which is equal to a constant \(r\) times the amount by which the payment exceeds his budget. The constant \(r\), called the borrowing rate, is the same to all bidders. The object being auctioned has uncertain value, which is either zero with probability \(\theta\), or a positive number \(v\), and both \(\theta\) and \(v\) are common knowledge to the bidders and the seller. The paper obtains a closed-form solution of this auction game. It predicts a bidding equilibrium that changes discontinuously in the borrowing rate \(r\). When \(r\) is above a threshold, high-budget bidders win, and the likelihood of bankruptcy is low. When \(r\) is below the threshold, the winner is the most budget-constrained bidder and is most likely to declare bankruptcy. The result is used to explain the ``high bids and broke winners'' anomaly in the C-Block FCC spectrum auction. Based on its equilibrium analysis, the paper proves that a seller can profit from offering to finance the highest bidder at a below-market interest rate, even with default risk.