On favoritism in auctions with entry 1

Leandro Arozamena2
Universidad Torcuato Di Tella and CONICET

Federico Weinschelbaum3
Universidad de San Andrés

February 2010

Abstract

We examine the problem of endogenous entry in a single-unit auction when the seller’s
welfare depends positively on the utility of a subset of potential bidders. We show that, unless
the seller values those bidders’welfare more than her own “private”utility, a nondiscriminatory
auction is optimal.

Keywords: auctions, favoritism, free entry, endogenous number of bidders.

JEL classi…cation: C72, D44.
1
We acknowledge …nancial support from FONCyT, PICT 2255.
2
Corresponding Author. Address: Saenz Valiente 1010, C1428BIJ Buenos Aires, Argentina. E-mail: laroza-
[email protected]. Phone: 54-11-5169-7300. Fax: 54-11-5169-7348.
3
Address: Vito Dumas 284, B1644BID Victoria, Buenos Aires, Argentina. E-mail: [email protected].
Phone: 54-11-4725-7041. Fax: 54-11-4725-7010.

1
1 Introduction
The most important results in auction theory hold under the assumption of a …xed number
of bidders. However, as Klemperer (2004) claims, one of the key issues regarding auction
design is how to encourage entry. For instance, Engelbrecht-Wiggans (1987) suggests that New
York consolidated as the main port of the US East Coast (over Philadelphia and Boston) after
passing legislation (with the express intention of attracting bidders) that required that all goods
o¤ered at auction at the New York port should be sold without reservation price to the highest
bidder. Another issue that arises quite frequently when auctions are employed, especially in
procurement, is whether some of the bidders should be given preferential treatment, e.g. in
public procurement when domestic …rms have some form of advantage in the bidding process
over their foreign rivals. One reason -although not the only possible one- for awarding such
a preference is that favored bidders’ welfare positively in‡uences the seller’s welfare. In our
previous example, it may be the case that domestic …rms generate more tax revenue than
their foreign rivals. Alternatively, the seller and some of the bidders may be …rms in the same
conglomerate.
Some papers, which we brie‡y discuss below, study auctions with endogenous entry, but
in all of them the seller’s utility is not a¤ected by the utility of any of the bidders. Another
branch of the literature, which we also discuss below, analyzes auctions where the seller’s welfare
depends on the utility of some of the bidders, but all of them study the case of a …xed number
of bidders Here, we examine the problem of endogenous entry when the seller’s welfare depends
on the utility of a subset of potential bidders. To the best of our knowledge this note is the
…rst to deal with this problem.
The literature of endogenous entry in auctions can be divided into two groups. First, there
are models in which the entry decision is made after each bidder knows her valuation. This set
of papers starts with Samuelson (1985) and includes Stegeman (1996), Menezes and Monteiro
(2000), Celik and Yilankaya (2009) and Li and Zheng (2009), among others. Alternatively, there
are models where the decision is made before the valuation is realized, which is the assumption
we adopt. These models start with McAfee and McMillan (1987) and Engelbrecht-Wiggans
(1987) and include Engelbrecht-Wiggans (1993); Levin and Smith (1994) and Ye (2004).
As for the issue of favoritism in auctions, La¤ont and Tirole (1991) and Vagstad (1995) study
the case of multidimensional auctions, where favoritism may appear when the auctioneer as-
sesses product quality. McAfee and McMillan (1989), Branco (1994) and Naegelen and Mougeot
(1998) examine single-dimensional auctions, where price-preferences may be used. The basic

2
result is that the optimal allocation rule follows from comparing the maximum valuation of the
preferred bidders with the maximum “virtual”valuation of the non preferred bidders. A usual
way to discriminate, known as right of …rst refusal, is giving one of the preferred bidders the
right to match the highest bid that any of her rivals may submit. This right has been stud-
ied in Walker (1999), Burguet and Perry (2009), Bikhchandani et al. (2005), Arozamena and
Weinschelbaum (2006), Choi (2009) and Lee (2008).
In what follows, we allow for the possibility that the seller attaches a positive weight to
some bidders’ utility when computing her own welfare. However, once we endogenize entry,
we show that, unless that positive weight is larger than one (i.e. unless the seller values those
bidder’s welfare more than her own “private”utility), there is an optimal auction design which is
nondiscriminatory. The intuition is simple: whenever the seller is able to appropriate the whole
surplus in an e¢ cient auction, the joint surplus of the seller and the preferred buyers cannot be
improved, and it will certainly decrease whenever preferences introduce some ine¢ ciencies in
the auction. In our setup with an endogenous number of bidders, there are nondiscriminatory
auctions, which are e¢ cient, that allow the seller to appropriate the whole surplus. There
could be some way to discriminate without reducing the seller’s welfare, but it is not possible
to increase it. As a corollary, we show that awarding a right of …rst refusal to a preferred bidder,
generally reduces welfare.
It should be noted that the justi…cation for favoritism that we examine, which derives from
the fact that the seller values some of the bidders’utilities, is not the only possible one. With
a …xed number of bidders, favoring weak bidders raises revenue, as shown by optimal auction
theory. With endogenous entry, favoring weak bidders (which might otherwise not enter) may
also be optimal for the seller. Those arguments require asymmetry among bidders, while our
model is (but for the unequal consideration of bidders’ utilities by the seller) symmetric. In
sticking to symmetry, we concentrate on the reason for favoritism that we intend to question.
In the following section we present the model and the basic results.

2 The model
We start with the setup in McAfee and McMillan (1987). Speci…cally, the owner of a single,
indivisible object is selling it through an auction.4 For simplicity, we assume the seller attaches
no value to the object. There are N potential bidders, any of whom can enter the auction
4
All our results are valid as well in the case of procurement auctions.

3
upon paying a …xed cost k 0: After paying her entry cost, bidder i learns her valuation for
the object, vi ; which is distributed according to a c.d.f. F with support on the interval [v; v]
and a density f that is positive and bounded on the whole support. Bidders’ valuations are
independent. We assume that N is large enough so that if all potential bidders entered they
could not recover the entry cost.
The seller’s utility depends on the surplus of one of the bidders, the “preferred”bidder. We
assume that there is only one preferred bidder, although our arguments would generalize to
the case of any favored subset of f1; :::; N g: We want to characterize a selling mechanism that
maximizes the sum of the expected utilities of the seller and the preferred bidder -we assume
that the latter is bidder 1.5 Our problem is a modi…cation of the standard optimal auction
problem with independent private values.6 The seller and all bidders are risk neutral.
Let B be the set of bidders that enter the auction. The timing is as follows. First, the seller
announces the auctioning mechanism. In principle, she could condition that mechanism on
the subset of entering bidders, so she has to announce functions HiB ((vi )i2B ); PiB ((vi )i2B ); B 2
2f1;:::;N g7 . HiB ((vi )i2B ) (PiB ((vi )i2B )) is the probability that bidder i gets the object (respectively,
the price bidder i has to pay to the seller) if B is the set of bidders that enter the auction and
their valuations are given by (vi )i2B . Once that announcement is made, the N potential bidders
simultaneously make their entry decisions. We focus on pure-strategy equilibria of the entry
game. Those bidders who have entered learn their valuations and take part in the announced
direct mechanism that corresponds to the actual set of entrants.
Bidder i’s expected utility when she belongs to B; her valuation is vi ; and she decides to
enter the auction expecting that all the other members of B will enter as well, is

Ui (vi ; B) = hi (vi ; B)vi pi (vi ; B);

where hi (vi ; B) = Ev i [HiB ((vj )j2B )] and pi (vi ; B) = Ev i [HiB ((vj )j2B )]; i 2 B:
The mechanism announced by the seller has to satisfy the corresponding incentive compat-
ibility
Ui (vi ; B) hi (vi0 ; B)vi pi (vi0 ; B) for all B, for all i 2 B, for all vi ; vi0 (1)
5
Our results generalize to the case where the seller attaches a weight lower than one to the preferred bidder’s
utility.
6
See Myerson (1981) and Riley and Samuelson (1982).
7 f1;:::;N g
2 is the power set of f1; :::; N g:

4
and participation constraints8

Ui (vi ; B) 0 for all B, for all i 2 B, for all vi (2)

Given the seller’s announcement, the equilibrium set of bidders, B , will be such that
Rv
Ui (vi ; B )f (vi )dvi k; 8i 2 B
Rv v (3)
v
U j (v j ; B [ j)f (v j )dv j k; 8j 2
= B

The seller’s problem is then9

XZ v Z v
max pi (vi ; B )f (vi )dvi + U1 (v1 ; B )f (v1 )dv1 k
H1B (v1 ;:::;vn );P1B (v1 ;:::;vn ) v v
i2B
B22f1;:::;N g

subject to (1), (2) and (3).

If the set of bidders, B , were exogenously …xed, following the usual steps in the auction
literature, the seller’s objective function becomes
Z v XZ v
h1 (v1 )v1 f (v1 )dv1 + hi (vi )J(vi )f (vi )dvi
v i2B v
i6=1

1 F (v)
where J(v) = v f (v)
. The allocation that solves this problem is well known10
(
1 if v1 > maxi6=1 J(vj )
H1B ((vj )j2B ) =
0 otherwise
(
1 if J(vi ) > maxfv1 ; maxj6=i J(vj )g
HiB ((vj )j2B ) =
0 otherwise
for i 6= 1: This is a discriminatory rule. However, when there is free entry of bidders the
result substantially changes. The allocation rule, as we show in the following proposition, is a
nondiscriminatory one.

Proposition 1 The allocation rule that maximizes joint expected surplus is a non discrimina-
tory one. A …rst price or a second price auction that treats equally the favored and the non
favored bidders maximizes joint surplus.
8
Even after having paid the entry cost k; once she knows her valuation a bidder may choose not to take part
in the selling mechanism.
9
We are implicetly assuming that bidder 1 always enters. If this were not the case, the second and third
terms in the objective function would disappear.
10
See for example Arozamena and Weinschelbaum (2006).

5
Proof. The expected value of the game (i.e. the expected total surplus in the auction)
is the winning bidder’s expected valuation minus the entry cost paid by entering bidders:
Ev #(B )k:11 This, in turn, has to equal the expected revenue of the seller plus the summation
of the surpluses of each of the bidders. As shown in McAfee and McMillan (1987), the allocation
rule that maximizes expected total surplus by generating optimal entry awards the object to
the entrant with the maximum valuation. If we ignore that the number of entrants has to be
an integer, a …rst price or a second price auction with a reservation price equal to the seller’s
valuation maximizes the expected value of the game, and the seller receives the whole surplus.
Considering the integer constraint, as McAfee and McMillan (1987) show, the seller can still
maximize the value of the game and receive the whole surplus by charging an entry fee exactly
equal to each entrant’s expected utility when the number of entrants is the largest integer lower
than the optimal number of entrants in a continuum.12
It just remains to prove that when the seller cares about bidder 1’s surplus she cannot
do better. If she could, she would be getting more than the maximal value of Ev #(B )k.
Thus, at least one of the bidders has to receive a negative expected surplus, which is clearly
impossible

Note that the seller does not care if the favored bidder is in the set of entrants or not. This is
because the expected surplus of each of the bidders is zero. The seller can give a subsidy to the
preferred bidder to induce him to enter, but she would still get the same utility. But whenever
the bidders that have entered are treated di¤erently in the bidding process an ine¢ ciency is
created, and the seller’s utility decreases.
The result holds for any number of preferred bidders whenever their surplus enters in the
seller’s utility function with a weight less than or equal to one. More generally it holds for
any equilibrium in which the value of the game is maximized and the seller receives the whole
surplus.
The result applies as well if we consider the symmetric, mixed-strategy equilibrium of the
entry game studied in Levin and Smith (1994), since in that case the seller still receives the whole
surplus. However, symmetric, mixed-strategy equilibria of the entry game are ine¢ cient. The
seller has incentives to induce some bidders to enter and move from the symmetric equilibrium
11
#(B ) denotes the cardinality of the set B :
12
Actually, as pointed out in Engelbrecht-Wiggans (1993), the seller may choose to subsidize entry so that
the number of bidders is the lowest integer larger than the optimal number in a continuum. This way, she would
still receive the whole surplus.

6
to an asymmetric, pure-strategy, e¢ cient one. These incentives are already present in Levin
and Smith (1994). It doesn’t matter if she subsidizes the preferred bidder or not: the seller is
indi¤erent among any of the possible ways of moving from the symmetric equilibrium to the
asymmetric one studied in McAfee and McMillan (1987).
Finally, as a corollary, note that whenever the seller gives a right of …rst refusal, if it matters,
she awards the right-holder some advantage in the bidding process. This advantage generates
an ine¢ ciency. Thus, the seller’s utility is reduced.

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7
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