Vickrey auctions?

I have no background in this area, and as an economic theorist, I would make an excellent gardener, so I may have missed the point entirely.

However various websites I visited have explained the Vickrey auction system as a system where all parties make a secret bid simultaneously. The highest bidder obtains the item but at the price offered by the second highest bidder.

The purported benefit of this model is that “bidders have the incentive to bid what they think the item is worth and not worry about what others will bid.” (cite: http://www.kunoozy.com/help/type_auction.cfm)

Am I missing something here? If everyone has an incentive to make a bid that is reasonable (to them), can’t the system be easily exploited by making sure your bid is the highest. As an extreme example, I mean bidding 1,000,000,000 to the power of 100 $ for a common pencil). As my bid is the highest, I get the pencil but only pay what the second highest bid was - which, according to the above cite, should be a reasonable figure.

I can see how people might come back and say the system works for precisely the reason that I outlined, i.e., if any two parties seek to exploit the system in the same way then one of them is going to lose bigtime, and this fact keeps the bids reasonable. But the paradox is (or appears to me to be) that if people can be counted on to make reasonable bids, then the system is open to exploitation. On the other hand, if people can’t be counted on to make reasonable bids then the purported benefit of the system is illusory.

What’s the deal?

Bidding your reservation price is a Nash strategy. If everyone else is bidding their true value, it is still worth you bidding your true value.

The key is that people’s subjective values of the object in question differ.

Suppose you have the highest valuation. Bidding above that valuation yields the same outcome for you as bidding your valuation. Bidding below it is a potential loss.

Suppose you do not have the highest value (remember, you don’t know this). Bidding your true value (or below) loses you nothing. Bidding above that value runs the risk that I pay more than my valuation (although not as high as my bid).

The deal is that bidders can bid safe in the knowledge that if they win, they won’t have to pay their bid amount…it’ll be something less. Consequently, there’s no incentive to low-ball. Having bidders bid big is not “exploiting” the system…it’s precisely why a Vickrey auction works.

The auction type that most laypeople are used to is an ascending oral auction, where the high bidder wins. Unfortunately for the seller (not the auctioneer), that high bid is theoretically not the highest price that the assembled bidders would pay, but the SECOND highest (plus the bidding increment). That is, bidders bid until only one remains, and s/he wins AT THE PRICE AT WHICH THE SECOND HIGH BIDDER DROPS OUT. We have no way of knowing how much higher the winning bidder would have gone.

With a Vickrey, however, bidders know they must bid relatively high to win, but are reassured (somewhat) in the knowledge that if they win, they’ll pay something less than their bid.

Auctions are not designed to benefit the bidders, and typically, the ‘reasonable’ bidder won’t win BECAUSE s/he is bidding reasonably.

OK! Thanks hawthorne and ricepad - I get it now. You were right, I was ignoring the fact that people’s reservation prices will differ. Doh!