Undercover Economist

The auction site that’s pure temptation

A New York Times columnist called it “devilish”. Jeff Atwood, a blogger, called it “about as close to pure, distilled evil in a business plan as I’ve ever seen”. Another online commenter called it an “evil hack of the human mind”. It’s Swoopo, or as The Register put it, “eBay’s (more) evil twin”.

Swoopo runs “pay-to-bid” auctions, where each bid costs you money. As a result, everyone who participates in the auction ends up paying something, and while the winner may get a bargain, all the losing bidders are out of pocket. The auction rules vary, but might specify that each new bid costs 60 cents and that each of those bids raises the price by just 12 cents.

Consider a $500 game console that sells for $240. The $240 winning bid is the 2,000th bid; Swoopo would have earned $240 for the winning bid, plus $1,200 in bid fees, for a $500 console. Sometimes bid increments are just one cent, meaning that even tiny winning bids can leave bidders collectively out of pocket.

Richard Thaler, a behavioural economist who also has a New York Times column, looked at 26 occasions on which Swoopo had simply auctioned $1,000 cheques. The average revenue was $2,452. No wonder the pitchforks are out.

When I heard of Swoopo, the first thing that sprang to my mind was not distilled evil, but an obscure piece of economics called the revenue equivalence theorem. The theorem, developed by Nobel laureate William Vickrey, shows that – given certain assumptions – all auctions can be expected to raise the same amount of cash for the seller. You can hold an open-outcry auction, or a descending-bid auction, or accept sealed bids in envelopes and charge the winner his bid, or the second-highest bid, or the third-highest bid. You can charge an entrance fee, or even insist that every single bidder forfeits his entire bid. The expected revenue, insists Vickrey, will be the same.

To get a sense of why this might be true, imagine an auction where the “evil” rule is that the winner pays twice his bid. Obviously, everyone in such an auction would simply bid half as much as they really intended to pay. The winning bid would be doubled and the final result would be no different. The revenue equivalence theorem is a more general proof of the same idea: “evil” auction rules simply encourage more cautious bidding – they don’t raise any more money.

Still, Vickrey’s theorem makes assumptions, including that of rational bids. Swoopo may attract foolish bids instead. Thaler looked at only 26 auctions, but two new research papers look at tens of thousands.

Three economists from Brigham Young University, Brennan Platt, Joseph Price and Henry Tappen, find that irrational – or perhaps simply risk-loving – bidders seem to concentrate on game consoles. The bids in other auctions look rational and are not especially lucrative.

Ned Augenblick, a doctoral student from Stanford University, has more data and is more pessimistic: he reckons that the typical Swoopo item raises about 50 per cent more revenue than its price on Amazon. This may not be a grotesque profit margin, but it is certainly handsome.

Both studies conclude that many, perhaps most, Swoopo auctions lose money, but that Swoopo makes up for this because some auctions are very profitable indeed. So perhaps Swoopo is a “hack of the human mind”. Augenblick can identify what the hack is, too: it takes advantage of what economists call the sunk cost fallacy. Bidders get sucked in, refusing to quit once they feel committed by having made a few bids.

Pure, distilled evil? I’d sooner slap that label on slot machines. But I won’t be playing Swoopo in a hurry.

Also published at ft.com.