A Note on Bidding Strategies

c yvind Norli, January 2012

Contents
1 Introduction

2 Private value
2.1 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2 Optimal bidding in a private value auction . . . . . . . . . . . . .
2.3 Optimal bid with toehold . . . . . . . . . . . . . . . . . . . . . .

1
2
2
3

3 Common value
3.1 Optimal bidding in a common value auction . . . . . . . . . . . .
3.2 Optimal bid with small strategic advantages8 . . . . . . . . . . .

5
6
8

A Private value no toehold

11

Introduction

During the first class of Applied Valuation you will be introduced to auctions.
The main purpose of is to develop an understanding of the Winners Curse.
We will explore bidding strategies in auctions through various in class
auctions. To prepare for class you only need to familiarize your self with the
following terms: Private value auction, common value auction, Winners Curse,
and toehold. Before class, you do not need to worry too much about the optimal
bidding strategies described in this note.

Private value

In a private value auction, each bidder has a private value for the item being
sold in the auction. For example, if you are bidding for a bottle of vintage wine

Bidding strategies

that you plan to consume yourself (say a 1959 Chateau Mouton Rothschild
because you feel rather like James Bond), you will have a private value for the
object up for sale. Your value will typically be different from the value put on
the object by other bidders. In a takeover context, bidders could have private
values for the target if they have vastly different plans and abilities to utilize
the targets assets. In other words, the synergies between the bidders and the
target are unique to each bidder. When modeling a private value auction, it is
typically assumed that each bidder knows his own private value, but only have
an uncertain estimate of the private value of competing bidders.

2.1

Model

Assume that there are two corporate bidders for a target. We refer to the bidders
as bidder 1 and bidder 2. They have private values v1 and v2 for the target.
To simplify the analysis, assume that v1 and v2 are independently uniformly
distributed on the interval [0, 1].1 Table 1 shows some useful properties for this
distribution.
Table 1 Properties of the [0, 1] uniform distribution
Probability of drawing a number x less than X:
Probability of drawing a number x higher than X:
Probability of drawing the number X1 [0, 1]:
Expected value of x conditional on being less than X:

Pr(x < X) = X
Pr(x > X) = 1 X
Pr(x = X1 ) = 0
E(x | x < X) = 21 X

Each bidder knows his own value, but only knows that the other bidders
value is uniformly distributed on [0, 1]. The bidding is done using a Japanese
auction. That is, bidders maintain a signal showing that they are still in the
auction, for example, by holding their hands in the air. When the price goes
above the maximum bid a bidder is wiling to make, the bidder discontinues
his signal (dropping his hand.) The auction has winner when there is only one
bidder left. This implies that the winner pays the price at which the next to the
last bidder dropped out. A bidding strategy is a price, p, at which a bidder will
drop out. It seems logical that the optimal bidding strategy for a bidder will
be a function of his private value. Lets recognize that by writing the optimal
bidding strategy as pi (vi ), where vi is the private value for bidder i = 1, 2.
Thus, our search for an optimal bidding strategy is a search for the function
pi (vi ) that maps value into a price.

2.2

Optimal bidding in a private value auction

This is the simplest of all the cases we will look at. The optimal bid is to stay
in the auction until the price reaches the private value. Using the notation
established above, we have: pi (vi ) = vi . Why is this optimal? Well, because it
1 This means that the value v can take on values between 0 and 1, that any value is equally
1
likely, and that the realized value of v1 is not related to the value of v2 .

Bidding strategies

is not optimal to quit at prices higher than vi since this would imply a loss of
(vi pi ) < 0 if you won the auction. It is not optimal to quit at prices lower
than vi since by staying in the auction you have a chance of winning at a price
lower than your valuationwhich implies a positive gain. Example 1 shows a
simple numerical illustration of this argument. Appendix A contains a formal
proof of pi (vi ) = vi .
Example 1 Private value auction without toehold
Suppose bidder 1 has a private value of 10 (v1 = 10.) If she bids higher than
10, say 12, and wins the auction she will realize a loss of 2. For any price
higher than 10, she will realize a loss if winninghence, it can never be part of
an optimal bidding strategy to bid beyond her private value.
Suppose she quit at a price below 10, say 8, while there are other bidders that
are still active. She will then not win the auction and realize a profit of zero.
By remaining in the auction a little bit beyond 8 there is a chance that she will
winresulting in an expected profit greater than zero. Hence, it can never be
optimal to quit below your private value (when other bidders are active.)

2.3

Optimal bid with toehold

A small ownership in the target prior to launching a tender offer is referred to

as a toehold. Assume that bidder 1 has a toehold 1 < 0.5 and that bidder 2
does not have a toehold. This will change the optimal bidding strategy for the
toeholder. The reason is that bidder 1 will sell his toehold to bidder 2 if bidder
2 wins the auction. This gives bidder 1 a strong incentive to make sure that
bidder 2 pays a high price whenever he wins.
Following the logic of section 2.2, the optimal strategy for the bidder without
a toehold is to remain in the auction until the price reaches his private value
(p2 = v2 .) For bidder 1, it will still not be optimal to quit at a price lower than
his private value. However, it will be optimal to remain in the auction at price
levels that exceeds the private value. Assuming that the price has reached the
valuation of bidder 1 and bidder 2 is still active, it will be profitable for bidder
1 to remain in the auction since this drives up the price bidder 2 will pay for the
toehold, while only resulting in a very small probability of winning the target
at this price (notice that the price now is higher than v1 , so bidder 1 really do
not want to acquire the target). In other words, it is optimal for the toeholder
to bid the price up under the competing bidder.
Deriving the optimal bidding strategy for the toeholder. From the
perspective of bidder 1 (the toeholder,) the problem is to choose a price level p1
at which it will be optimal to quit the auction if bidder 2 is still active. First, we
need to determine what we should assume about bidder 2s behavior. It seems
reasonable to assume that bidder 2 will follow the optimal bidding strategy for

Bidding strategies

a bidder without a toehold, that is, p2 = v2 . From bidder 1s perspective, this

implies that bidder 2s maximum bid (i.e., how long bidder 2 will stay in the
auction) is uniformly distributed on [0, 1]. In other words, bidder 1 can view
p2 as a random variable. Second, bidder 1 needs to determine the price level,
p1 , that maximizes his expected profit in the auction. If bidder 1 remains in
the auction until the price reaches p1 , the expected profit for bidder 1 can be
written as follows (please do not freak out!this is not as complicated as it
looks):
Pr(p1 < p2 ) [1 p1 ] + Pr(p1 > p2 ) [v1 (1 1 )E(p2 | p2 < p1 )]
Let me explain the components of this expression. First, Pr(p1 < p2 ) is the
probability that bidder 1 loses the auction. In other words, if bidder 1 quits at
p1 , Pr(p1 < p2 ) is the probability that the optimal bid for bidder 2 is higher
than p1 (in which case bidder 1 loses.) If bidder 1 drops out at p1 and bidder
2 wins the auction, bidder 2 pays p1 for bidder 1s toehold 1 . Thus, the first
term is the value to bidder 1 if he loses the auction times the probability that
this happens.
Second, Pr(p1 > p2 ) is the probability that bidder 2 optimally quits before
p1 leaving bidder 1 as the winner. The term [v1 (1 1 )E(p2 | p2 < p1 )]
is the expected profit to bidder 1 conditional on winning the auction. The
expected profit is computed as the difference between the private value, v1 ,
and the expected price, E(p2 | p2 < p1 ), paid for the fraction of the company,
(1 1 ), that bidder 1 does not already own. Remember that when bidder 1
wins the auction, he will pay the price at which bidder 2 drops out. Thus, the
expected price is just the expected value of the random variable p2 conditional
on p2 being less than p1 .
Using Table 1, we have Pr(p1 > p2 ) = p1 , Pr(p1 < p2 ) = 1 p1 , and
E(p2 | p2 < p1 ) = (1/2)p1 . Thus, we can rewrite bidder 1s expected profit as:


1
(1 p1 )1 p1 + p1 v1 (1 1 ) p1
2
The optimal strategy for bidder 1 is the p1 that maximizes the above expected
profit. So, we take the partial derivative of the expected profit with respect to
p1 . This gives the first order condition:
p1 =

v1 + 1
1 + 1

This is bidder 1s optimal bidding strategy as a function of the toehold and his
private value. That is, given that bidder 2 is still active, bidder 1 should bid up
to p1 to maximize the expected profit from participating in the auction.
To see that this bidding strategy implies that the toeholder optimally bids
more than his valuation, we add and subtract v1 on the right hand side and
rearrange to get:
1 (1 v1 )
p1 = v1 +
1 + 1

Bidding strategies

That is, bidder 1 bids more than his private value for all private values less than
one. Since, we assumed that v1 is uniformly distributed on [0, 1] this implies
that he almost always overbids. The intuition for this result is as follows: When
the price has reached v1 bidder 1 will consider two effects of continued bidding.
1. Continued bidding will drive up the price at which he can sell his toehold
to bidder 2.
2. Continued bidding implies that there is a chance that he will win the
auction at a price higher than v1 hence realize negative profit.
However, by bidding only a little bit higher than v1 , say up to p0 > v1 , there is
only a very small probability that bidder 2 happens to optimally quit between
v1 and p0 . Thus the expected loss from bidding up to p0 is very small while the
expected gain is (p0 v1 )1 almost for sure.2

Common value

In a common value auction, the value of the item being sold is the same for
all bidders. If I were to auction off the contents of my wallet, this would be a
common value auction.3 The bidders for my wallet would be allowed to observe
the size of my wallet to form an opinion on how much it contains in term of
valuables. In this situation, each bidder would presumably come up with a
different estimate of the true value of my wallet. Thus, a common value
auction involves an object with a common value for all bidders, but, bidders
have different estimates of the common value. In a takeover context, think of
common value as the intrinsic value of a target. Bidders form an opinion on
the value of the target by forecasting free cash flow, estimating cost of capital,
and discounting to get an estimate of this intrinsic value. Each bidder knows
that his valuation and all the other bidders valuations are uncertain estimates
of the intrinsic value.
In the 1950s the US federal government started to auctions off production
rights to oil and gas deposits on offshore public land. The patch of land to
be auctioned off is referred to as a tract. A tract typically consists of 5,000
acres. Private oil companies bid for the rights to drill for oil on the tract. Prior
to bidding the oil companies were permitted to gather information about the
tract using seismic surveys or off-site drilling (no on-site drilling was allowed).
Initially, these offshore oil wells were unprofitable. The problem turned out to
be the bidding process together with the large uncertainty embedded in the
seismic information used by oil companies to value the oil tracts.4
2 Suppose the probability that bidder 2 quits in the interval [v , p0 ] is q 0. Then, the
1
expected loss from continued bidding is (p0 v1 )q 0 while the expected gain is (p0 v1 )(1
q)1 (p0 v1 )1 .
3 It would also be a low-value auctionwhich, of course, is beside the point.
4 See Competitive bidding in high risk situations, Capen, Clapp and Campbell, Journal
of Petroleum Technology, 1971.

Bidding strategies

To illustrate the problem faced by the oil companies, consider the following
simple example. Suppose the intrinsic value of a tract is $22.5 million net of the
costs to get the oil out of the ground.5 There are four oil companies bidding
for the tract. Based on their private seismic surveys they have come up with
four different intrinsic values net of costs: $15 million, $20 million, $25 million
and $30 million. Notice that the average value of the four estimates is equal to
the intrinsic value of the tractthus, the oil companies get it right on average.
Suppose the bidding for the tract went on like the following: At $15 million the
first firm drops out, at $20 million the second firm drops out, and at $25 million
the third firm drops out. Thus, the winner is the firm that valued the tract at
$30 million and they are happy with the outcome because they only paid $25
million. The problem is that the tract only is worth $22.5 million which implies
that they will incur a loss of $2.5 million from the tract. The winner of this
auction has suffered what is called the Winners Curse. In this auction, the
prize went to the firm with the most optimistic view of the value of the object
up for sale. Unless bidders take the Winners Curse into account, the winner
of a common value auction will be the person that has overestimated the value
the most. An optimal bidding strategy, though, will take the Winners Curse
into account by shaving the bidsthat is, bid less than the expected value of
the object.

3.1

Optimal bidding in a common value auction

This time, assume that there are three bidders for a target. The auction mechanism is still a Japanese auction. The bidders have analyzed the target and
established value estimates v1 , v2 , and v3 . The value estimates are independent
draws from some commonly known continuous distribution. The common value
for the target is:
1
v = (v1 + v2 + v3 )
3
All bidders realize that the target value is determined in this way and will bid
accordingly.6
We will be looking for a symmetric equilibrium. That is, the bidders use the
same optimal bidding strategy as a function of their valuation. Therefore, two
bidders with the same value will quit from the auction at the same price. Also,
a bidder with a low estimate will quit before a bidder with a higher estimate.
Imagine that we rank the value estimates according to their value as follows:
v(3) < v(2) < v(1) . Thus, v(1) is the bidder with the highest valuation. This
could be either bidder 1, bidder 2, or bidder 3. Notice that the bidders will, of
course, not know this ranking. The first bidder to quit in the auction will be
bidder v(3) and this bidder will optimally quit when the price reaches v(3) . To
see why this is optimal, consider the following two arguments:
5 The

intrinsic value of a tract depends on the amount of oil and the oil price.
is just a simple way to get the model to reflect that all bidders estimates are unbiased,
although uncertain, estimates of the target value.
6 This

Bidding strategies

A1 If no other bidder has quit and bidder v(3) continues to bid beyond v(3) ,
say up to p0 > v(3) , and find himself as the winner, it must be because
all other bidders have estimates lower than or equal to p0 . At best, they
all have estimates p0 . But then, v = (1/3)(v(3) + p0 + p0 ) < p0 . Thus,
winning at p0 for bidder v(3) implies a loss. Making p0 arbitrarily close to
v(3) shows that it will never be optimal to quit at any price above v(3) .
A2 Define prices p0 and p00 such that p0 < p00 < v(3) . Consider the situation
when no bidder has quit and the price has reached p0 . If bidder v(3) quits
at p0 the expected profit is zero. The reason for this is that there is zero
probability that the other two bidders optimally quit at p0 . If bidder v(3)
instead decides to continue to bid up to p00 there is a positive probability
that the other two bidders quit between p0 and p00 , in which case bidder
v(3) makes a profit that at worst is: (1/3)(v(3) + p00 + p00 ) p00 > 0. Making
p0 arbitrarily close to v(3) establishes that it will never be optimal to quit
at any price below v(3) .
Next we derive the price at which we should observe the second quit. All bidders
understand what the equilibrium bidding strategies are, therefore, they know
that the first quitter had a value estimate of v(3) . Following the logic of A1 and
A2, the other bidders will remain in the auction until they make zero profit if
they quit and win the auction but will make a negative profit if they continue
and win the auction. The next bidder to quit the auction will be bidder v(2)
and this bidder will quit when the price reaches
p =

1
(v(3) + v(2) + v(2) ).
3

If bidder v(2) quits at this price and find himself as the winner of the auctionit
implies that the other bidder quit at the same price. The other bidder will only
quit at the same price if he has the same value estimate as bidder v(2) . Thus
the value of the target, conditional on bidder v(2) winning, is p . Winning the
target at any price above p would result in a loss for bidder v(2) hence he
optimally quit at p . Since v(2) is the next to the last bidder to quit, bidder
v(1) will win the auction and pay p for the target. The profit earned by the
winning bidder is:
(1/3)(v(3) + v(2) + v(1) ) p
=
(1/3)(v(3) + v(2) + v(1) ) (1/3)(v(3) + v(2) + v(2) ) =
(1/3)(v(2) v(1) )
> 0
The are three crucial insights here. First, the equilibrium bidding strategies
prescribe that bidders should quit at the price where they expect to make no
profit as winners at the current price. Second, bidder v(2) only cares about the
value of the target conditional on being the winner. When there are two bidders
that remain active, and one bidder decide to quit at v(2) and then find himself
as the winner of the auctionit means that the other bidder quit at the same

Bidding strategies

price and that the other bidder has the same value estimate.7 This determines p
above. Third, the equilibrium bidding strategies take the Winners Curse into
account. Conditional on the price having reached v(2) , the expected value of the
target is higher than v(2) , since the other bidders signal is at least v(2) (otherwise
he would already have dropped out) and on average it will be higher than v(2) .
However, it is still optimal for bidder v(2) to drop out at v(2) . Again, the reason
is that he is not concerned with the expected value of the other bidders signal,
but with the expected value of the other bidders signal conditional on winning
the auction.

3.2

Optimal bid with small strategic advantages8

A bidder that receives a small bonus if he wins an auction will have an advantage relative to bidders that does not receive such a bonus. Even a very
small advantage in a common value auction can result in a huge increase in
the probability of winning the auction and also result in a very low winning
bid. The Los Angeles PCS license in the Airwaves Auction has been viewed as
an example of the big effects caused by a relatively small advantage. Pacific
Telephone was bidding with an advantage in this auction. They had a database
of potential local costumers for the new wireless phone service, its brand-name
was well known in the region, and its executives was familiar with California.
Pacific Telephone ended up winning the auction at $26 per head of population.
This compares very favorable to the price of $31 paid in Chicagoeven though
Chicago generally was viewed as a less promising area for the new service.
To illustrate how a small bonus affects optimal bidding consider the following
simple example. Two bidders are given value signals vA and vB . The signals are
independent and continuously distributed on [v, v]. The object they are bidding
for is worth vA + vB . Assume that vA happens to be greater than vB . Without
advantages to any of the bidders, we know (using the logic from A1 and A2
above) that bidder B will drop out at 2vB . Thus, bidder A wins the auction
and pays 2vB . This gives him a profit of vA vB > 0. If you are still reading,
take a deep breath, the next paragraph is going to get your eyeballs rolling.
Next, change the rules of the auction to include a small prize x given to
bidder B if he wins the auction. Given that v is the highest possible signal that
any bidder can get, bidder A should never bid more than vA + v. Whenever
bidder B gets a signal vB that is greater than v x he should never quit. The
reason for this is:
7 In a Japanese auction it is possible to be the winner even if you quit when there are
other bidders that are active. If all the remaining bidders quit at exactly the same price, the
auctioneer must have some mechanism to allocate the object. This could, for example, be a
random draw among the bidders that remained in the auction to the end and quit at the same
price.
8 This section draws extensively on Auction with Almost Common Values: The Wallet
Game and its Applications, by Paul Klemperer, European Economic Review 1998, 42(3-5),
757769.

Bidding strategies

i. At any price P reached in the auction, bidder B knows that

P vA + v

vA P v

ii. The profit for B if winning at P is x + vA + vB P (remember that B is

getting a prize x if he wins the auction). Using the fact that vA P v,
the profit for B is at least as big as
x + (P v) + vB P = x v + vB
iii. This profit is positive when vB > v x.
Thus, as long as vB > v x, the profit to bidder B is always positive and he
should never quit. Taking this into account, bidder A should never bid more
than vA + (v x). If he does and wins the auction, it implies that bidder B
must have had a value vB less than v x, in which case bidder A would realize
a negative profit. This, in turn, implies that whenever bidder B gets a signal
vB that is greater than v 2x he should never quit. The reason for this follows
the logic of arguments (i) through (iii) above. The chain of arguments can
be repeated until you have showed that bidder A will never bid higher than
the lowest possible value of the objectwhich from bidder As perspective is
vA + v. Bidder B will, of course, realize this and will never quit. Bidder B ends
up winning the object for sure, pay a price equal to vA + v, and make a profit
equal to vB + x v > 0.
There are two important insights here. First, bidder B will win the auction
even if his value estimate vB is lower than bidder As value estimate. Second,
bidder B will win the auction with probability 1 regardless of the size of the
strategic advantage. It is in this sense a small advantage for one bidder can
have a huge impact on the outcome and price realized in the auction.
Bidding for a takeover target with a toehold
Consider two bidders that are bidding for a target. Let p1 and p2 be the prices
at which bidder 1 and bidder 2, respectively, would optimally quit in the notoehold case. Assume that bidder 1 has a toehold, 1 < 0.5, in the target
and that bidder 2 does not have a toehold. The toehold of bidder 1 gives him
a strategic advantage in the auction for the same reason as the prize x gave
bidder B an advantage (see the section above.)
The toehold of bidder 1 implies that bidding the price  higher than p1 earns
him a fraction 1 of  with a probability very close to 1, but with a really small
probability he wins the auction and loses (1 1 ). Since,
(1 )1  (1 1 ) = (1 ) > 0
for small ,9 bidder 1 optimally bid higher than p1 . For bidder 2, this implies
that for any price at which bidder 1 quits the corresponding value estimate, v1 ,
9 Notice

that is a function of . The bigger you take  the bigger will be.

Bidding strategies

10

is lower than in the no-toehold case. Therefore, bidder 2 optimally bids less than
p2 . This again reduces the winners curse problem for bidder 1, resulting in an
even higher optimal bid. In turn, this reduces the optimal bid for bidder 2. This
argument can be repeated over and over again. As in the previous section, it will
not be optimal for bidder 2 to bid beyond the lowest possible value the target
can have from his perspective. If we model target value as (1/2)(v1 + v2 ) and
assume that the value estimates are drawn from the uniform [0, 1] distribution,
the lowest possible value will be half his own valuation, (1/2)v2 .

Bidding strategies

11

Private value no toehold

Using the model from section 2.1, the claim is that the optimal bidding strategy
is to bid up to your private value as long as other bidders remain active. The
trick will be to argue that it is never optimal to quit below your private value
and that it is never optimal to quit above your private value.
First, we show that it is not optimal to quit below v1 for bidder 1. Suppose
the price has reached p00 < v1 and that bidder 2 is still active. If bidder 1 quits
she will get zero profit. Define another price p0 such that p00 < p0 < v1 . Since v2
is continuously distributed on [0, 1], there is a positive probability that bidder 2
will quit between p00 and p0 if bidder 1 decides to remain in the auction. If bidder
2 quits between p00 and p0 , bidder 1 will make a profit of at least vi p0 > 0.
Thus, when the price reaches p00 , the expected profit for bidder 1 from remaining
in the auction until the price reaches p0 is positive. You can pick p00 as close you
want to v1 and the above argument still goes through.
Second, we show that it is not optimal to quit above v1 for bidder 1. Suppose
the price reaches v1 and bidder 1 decides to remain in the auction until the price
reaches p00 > v1 . Since there is a positive probability that bidder 2 quits at a
price between v1 and p00 , the expected value for bidder 1 from remaining in the
auction until p00 is negative. Again, you can pick p00 as close you want to v1 and
the argument still goes through.