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MASTER FILES ROOM C-525 0440 This is a Working Paper and the author would welcome any IMF WORKING PAPER comments on the present text Citations should refer to a Working Paper of the International Monetary Fund, men- tioning the author, and the date of issuance. The views © 1993 International Monetary Fund expressed are those of the author and do not necessarily represent those of the Fund. WP/93/ 12 INTERNATIONAL MONETARY FUND Research Department Auctions: Theory and Possible Applications to Economies in Transition Prepared by Robert A. Feldman and Rajnish Mehra Authorized for Distribution by Mohsin S. Khan February 1993 Abstract A major effort is taking place in many parts of the world to establish market-oriented institutions, a development that is particularly evident in the context of the transforming economies in Eastern Europe and the republics of the former Soviet Union. Against this background, this paper assesses various auction techniques to price and allocate government securities, refinance credit, foreign exchange, and state assets in the context of privatization programs. Before making our recommendations on the appropriate format for auctioning these items, the paper explains basic auction formats and assesses the advantages and disadvantages of these formats drawing on the existing, and mostly theoretical, literature. JEL Classification Numbers: C70, D40, D44, D60, P21, P23, P50 *Rajnish Mehra is Professor of Finance at the University of California at Santa Barbara. A first draft of this paper was completed while Professor Mehra was a visiting scholar in the Research Department. The authors would like to thank Eduardo Borensztein, V.V. Chari, Edward Dumas, Chi-fu Huang, Peter Isard, Mohsin S. Khan, Paul Milgrom, Merton Miller, Edward Prescott, Cheng-Zhong Qin and Vincent Reinhart for numerous helpful discussions and suggestions. David Cheney and E. Catherine Fleck provided useful editorial advice. Any errors are the authors' responsibility. The views expressed are those of the authors and not necessarily those of the International Monetary Fund. - ii - Table of Contents Page Summary iii I. Introduction 1 II. Types of Auctions 3 1. English Auction 3 2. Dutch Auction 3 3. First-Price Auction 4 4. Second-Price Auction 4 III. Auction Theory 6 1. The bidder's perspective 8 (a) Private-value assumption 8 (b) Common-value assumption 8 2. The seller's perspective 9 (a) Private-value assumption 9 (b) Common-value assumption 10 3. Efficiency considerations 12 4. Collusion 13 IV. Applications 15 1. Government securities 15 2. Refinance credit 18 3. Foreign exchange 20 4. Privatization 21 V. Summary and Conclusions 22 Table 1. Selected Characteristics of Different Types of Auctions 7 Figure 1. Auction Formats 4a References 24-26 - iii - Summary A major effort is taking place in many parts of the world to establish and improve market-oriented institutions. This development is particularly evident in the context of the transforming economies in Eastern Europe and the states of the former Soviet Union. Auction mechanisms are useful as one way of guiding price determination and the allocation process in a market- oriented setting. Indeed, introducing auction techniques for various commodities and assets can be used to help acclimate economic agents to operating in a world of market-determined and changing prices. One of the main goals of this paper is to survey the extensive literature on auctions in order to shed some light on the advantages and disadvantages of various auction techniques. A second goal is to assess the application of alternative auction techniques to four specific assets, namely, government securities, refinance credit, foreign exchange, and state assets in the context of privatization. In the process, the paper explains basic auction formats and tries to clarify some of the confusion that can arise because of the differing terminology applied to these formats. The paper concludes that auctions offer advantages of simplicity in determining market-clearing prices where markets may otherwise not exist and in allocating the auctioned items efficiently. The appropriate choice of auction format is less clear. This ambiguity stems in part from the difficulties in applying the theoretical literature to real world settings, and in part from the importance of individual country circumstances. When all is said and done, there are no unambiguous answers to the question of what is the best auction technique to use; this paper has tried, however, to rank the various auction formats according to their appropriateness in different circumstances. On balance, uniform second-price auctions are the preferred technique. They are simpler, perform well in terms of the expected revenue to sellers, and may offer considerable gains in promoting economic efficiency. In some circumstances, the English, ascending-price auction is more favorable but, at the same time, may be difficult to use because of technical consider- ations. English auctions are also more prone to collusive behavior. Discriminatory auctions would tend to be appropriate only in cases where collusion was considered to be a problem. The paper describes the advantages of double auctions in the case of foreign exchange. It emphasizes that irrespective of the choice of auction technique, every effort needs to be made to ensure that auctions are run on a competitive basis with safeguards against monopoly positions. This page intentionally left blank I. Introduction Auctions play an important role in economics. In their most basic form, they are simply one of the ways in which various commodities and financial assets are allocated to individuals and firms, particularly in a market-oriented setting. Examples of items that are commonly auctioned include original art, livestock, fresh fish, used cars, construction contracts, and a range of financial assets such as government securities, central bank refinance credit, foreign exchange, and equity shares. These items exhibit considerable diversity, but a common denominator among them is that the valuation of each item varies enough to preclude any direct and straightforward pricing schedule. The use of auction mechanisms to guide price determination and the allocation process has been associated with the major effort taking place in many parts of the world to establish market-oriented institutions. This development is particularly evident in the context of the transforming economies in Eastern Europe and the former republics of the Soviet Union. Examples of where auctions are particularly relevant include financial instruments such as Treasury (or government) securities, refinance credit, and foreign exchange, and state assets in the context of privatization. As the literature on auctions is extensive, one of the main goals of this paper is to survey and draw on this literature in order to shed some light on the advantages and disadvantages of various auction techniques. I/ A second main goal is to assess the application of alternative auction techniques to the four items mentioned above. We emphasize that the implications of theoretical models do not easily carry over into real world settings. Therefore, our recommendations on the appropriate auction technique for different assets depend heavily on individual country circumstances. Indeed, the array of country experience would suggest that there is no clearcut answer to the question of what is the appropriate auction technique. In this connection, it is instructive to note that in looking at the individual country experience across a range of countries--both industrial and developing--techniques used to auction similar items vary considerably. I/ Reviews of the literature on auctions in different contexts can be found elsewhere, and our paper builds on the insights of these authors. See Maskin (1992), McAfee and McMillan (1987), Milgrom (1985 and 1989), Milgrom and Weber (1982) and Smith (1987). In relation to recent assessments of the U.S. Government securities market, excellent reviews of selected aspects of auction techniques are contained in Bikhchandani and Huang (1992), Chari and Weber (1992), Reinhart (1992) and the Joint Report on the Government Securities Market (1992). - 2 - This experience includes several countries that in auctioning government securities have awarded them at whatever price was bid (e.g., France, Germany, Japan, and the United Kingdom), while others have charged a single, market-clearing price (e.g., Denmark and Switzerland). I/ Some countries have recently changed the way they run their auctions. In this regard, Mexico shifted from a multiple-price to a uniform-price approach in 1990 for Treasury bills, and then in 1993 shifted back. 2/ Italy, in 1991, switched from uniform to multiple pricing in its local-currency Treasury bill auctions, while Treasury bonds and ECU-denominated bills are auctioned on a uniform price basis. Currently, in the United States, the Treasury is experimenting with uniform price auctions for some government securities while also running discriminatory auctions. Relevant examples are also found for foreign exchange and refinance credit. Several countries have conducted discriminatory price or Dutch auctions for refinance credit (Romania) and for foreign exchange (Bolivia, Ghana, Jamaica, and Zambia). Other countries have used uniform price auctions for refinance credit (the former Czechoslovakia) and for foreign exchange (Guinea, Nigeria, and Uganda). 1/4/ Double auctions have been used for foreign exchange (Romania).

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