AUCTION PRICING: A CASE STUDY ASSESSING THE PRICE ELASTICITY OF DEMAND BASED ON SUPPLY AND THE REVENUE EQUIVALENCE THEOREM

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1 AUCTION PRICING: A CASE STUDY ASSESSING THE PRICE ELASTICITY OF DEMAND BASED ON SUPPLY AND THE REVENUE EQUIVALENCE THEOREM ABSTRACT Lovett, Marvin G. The University of Texas at Brownsville marvin.lovett@utb.edu Jones, Irma S. The University of Texas at Brownsville irma.s.jones@utb.edu This paper addresses the price elasticity of demand related to various categories of goods sold within the consignment auction-marketing environment. An actual ongoing non-traditional business organization specializing in the nation-wide distribution of merchandise via consignment auctions provides data for this case study. Originally developed and initiated in 1993 in response to the common need business organizations have for product liquidation outlets, this form of distribution targets audiences contemplating the distribution of products, including manufacturers, wholesalers, retailers, and other entrepreneurs. This method of distribution is the C.A.L.M. (The Consignment Auction Liquidation Marketing) Method of Mass Product Distribution. A summative evaluation regarding the C.A.L.M. Method of Mass Product Distribution was conducted in 2004 covering each of the first ten years of operation. For this paper, data from the final year of analysis, 2003, was used to assess the price elasticity of demand in relationship to quantities supplied. Traditional expectations relating to the laws of supply and demand leads to expectation of significant fluctuation in demand when supply changes. The Revenue Equivalence Theorem is an auction theory supporting the expectation of less fluctuation in demand regardless of the type of auction used. Although this paper does not address revenue expectations related to the type of auction format utilized, this paper does address revenue expectations related to two primary variables; final auction bids received and quantity of merchandise consigned. Therefore, this paper attempts to add upon the expectation of revenue equivalence regardless of auction type to include the influence of the laws of supply and demand. INTRODUCTION A common characteristic of human culture is the desire to acquire possessions. The existence of a wide assortment of goods available for individual use, such as clothing, adornments, food, weapons, tools, and so forth addresses this human need. The desire for individual possessions provides the means to engage in various purchasing and selling activities. In primitive cultures, most goods are produced within a household and exchanges of those goods are limited to minimal surplus production. As specialized production of a particular item creates surplus products, the need for exchanges through intermediaries or middlemen occurs (Alderson, 1954). During the late 1800s, a number of significant technological developments enabled the effective and efficient specialized production of particular products. These developments included steam power, railroad systems, and the theory of Scientific Management. Scientific Management theory applied practical management practices to the production of goods that resulted in increased factory output. This increased output (specialized surplus) then had to be distributed and sold (Converse, 1951).

2 AUCTION PRICING The increased production of goods leads to the topic of the marketing mix. Pricing is considered one of the four primary marketing tools referred to in the marketing mix. Besides pricing, the other three components of the marketing mix are product, promotion, and place (Kotler, 1996). Regarding place, an additional non-traditional channel of distribution presented here is referred to as the C.A.L.M. Method (Consignment Auction Liquidation Marketing Method). This method uses auction liquidation as its means of distribution and sale of goods. Consignment auction liquidation can provide an effective and profitable method for the mass distribution of products on a national basis. The Uniform Commercial Code defines an auction as a public sale of property to the highest bidder (Willner, 1966). Consignment auction outlets exist in almost every community throughout the United States. Although the internet-based consignment auctions, such as e-bay, are rapidly growing in popularity, the on-site, in-person consignment auctions still number in the thousands and are operating all over the United States. Although auctioneers first thought the Internet was a threat, the growth and development of searchable websites like AuctionZip have contributed to a jump in the live-auction industry, so much so that one-time rivals are now forming online partnerships that produce larger audiences for sellers. Toward that same end, buyers emboldened by success on ebay and other such sites are now seeking live auctions in search of lower prices and excitement of in-person competition (Auction Advantage, 2008). In 1993, the Gallup Organization reported that such consignment auction sales reached $70 billion annually. Milgram and Weber (1982) reported on the importance and use of auctions throughout history but also reported on the lack of research and the complexity involved in the auction method of distribution. Klemperer (2004), however, points out that auctions have become an important ground for economic theory, including game theory. Two basic auction designs identified by Klemperer (2004) are the ascending auction and the first price, sealed bid auction. The ascending auction is one in which the price/bid is raised until only one bidder remains. The first-price, sealed-bid auction based is based on bids submitted on a single, one-time basis. Consignment auctions follow the ascending auction design. Consignment auction outlets accept merchandise from consignors, sell that merchandise to the highest bidder, and withhold a consignment fee. These outlets are often referred to as an auction house, auction gallery, or auction barn. Regardless of the name, this method uses auction liquidation as its means of trade. PRICE ELASTICITY OF DEMAND The origin of trade has been the focus of economists and anthropologists for many years. The term trading is often used when referring to the sale of products. Trading is an act of affecting an exchange of goods or services between a seller and a buyer. It is considered, then, both a purchase and a sale. Although a number of theories exist regarding the origins of trade, one suggested essential prerequisite to trading is the development of the ability to valuate things in terms of other things (Walters & Robin, 1978). This valuation leads to the eventual establishment of a price, at which time, the market is said to be in a state of rest where the price and quantity will exist in a state of equilibrium (Hall and Lieberman, 2003). Within consignment auction environments, this state of equilibrium is repeatedly and rapidly achieved and varies dependent upon a number of variables, one of which includes the quantity of merchandise consigned. Due to the laws of supply and demand, it is expected that the varying quantities of merchandise consigned often results in fluctuations in prices or bids received. This tendency toward such fluctuations in prices or bids received is referred to as price elasticity. Price elasticity refers to the degree of sensitivity in demand demonstrated by consumers. Hall and Lieberman (2003) point out the difference in agendas for buyers and sellers. Although both sides desire and are able to trade, buyers strive to pay the lowest possible price while sellers strive to sell

3 for the highest possible price. Pride and Ferrell (2009) present a number of factors influencing the assessment of value including perceived value, perceived quality, and time constraints. The timepressured environment experienced between buyers and sellers within consignment auctions may result in price/bid instability and fluctuation. One important variable affecting this expected instability and fluctuation in price/bid relates to quantities of merchandise consigned. At times, excess demand may result in higher prices/bids due to a decrease in quantities supplied/consigned. Conversely, excess supply may result in lower prices/bids due to an increase in quantities supplied/consigned. However, Klemperer (2003) points to the Revenue Equivalence Theorem, which states that under certain conditions, the seller can expect, on the average, a stable price and profit from auctions, regardless of type of auction or product. The Revenue Equivalence Theorem, proposed by Vickrey (1961) projected that auction outcomes spring more from the auction process rather than merely the conditions of supply and demand. This rejection of the traditional neoclassical theory led Vickery to report various significant findings including what is now known as the Revenue Equivalence Theorem. Regardless of the type of auction, if the supply of items is stable, the same average receipts for the seller are normally achieved. The following hypotheses are presented to assess the influences of the laws of supply and demand within the traditional consignment auction environment and to test the expanded expectation of revenue equivalence. HYPOTHESES Hypothesis 1: A significant degree of price elasticity of demand will be demonstrated by a strong correlation between the independent variable, quantities of merchandise consigned, and the dependent variable, prices/bids received from consumers. Hypothesis 2: The degree of price elasticity of demand will vary significantly among the seven categories of merchandise consigned demonstrated by a categorical comparison of the correlation between the independent variable, quantities of merchandise consigned, and the dependent variable, prices/bids received from consumers. DATA ANALYSIS Data for this case study focuses on the analysis between the independent variable, quantities of merchandise consigned, and the dependent variable, prices/bids received from consumers. For the oneyear period encompassing January 1, 2003 to December 31, 2003, 14,504 pieces of merchandise, in varying quantities, were consigned to 94 consignment auction liquidation outlets all over the United States. The procurement cost for this consigned merchandise totaled $13,146 and the total proceeds or revenue received for this merchandise equaled $31,508. There was a gross profit margin of 139%. The performance of merchandise consigned is depicted in Table 1 below and is grouped into the seven categories. These categories are listed in the order of most to least profitable. Table 1: Categorized Merchandise Supplied - Time Period January 1, 2003 December 31, 2003 ITEM TOTAL NUMBER PROCUREMENT TOTAL GROSS OF PIECES COST REVENUE MARGIN Canes/Walking Sticks 1,418 $1,062 $3, % Cutlery 926 $1,487 $4, % Jewelry 5,348 $2,635 $6, % Toys/Children s Items 961 $1,684 $4, % Miscellaneous 2,376 $1,443 $2,856 98% Apparel 1,609 $1,139 $2,189 93% Specialty Items 1,866 $3,696 $6,783 84%

4 RESULTS For Hypothesis 1, the results that the correlation analysis between the independent variable, quantities of merchandise consigned, and the dependent variable, prices/bids received from consumers indicated price elasticity of demand but only to a mild degree as seen in Table 2 below. Therefore, the Null Hypothesis can be rejected. For Hypothesis 2, the results that the correlation analysis between the independent variable, quantities of merchandise consigned, and the dependent variable, prices/bids received from consumers did indicate variance as related to the seven categories of merchandise consigned but only to a mild degree as seen in Table 2. Therefore, the Null Hypothesis can be rejected. Table 2: Correlation Analysis between Quantities of Merchandise Consigned, and Prices/Bids Received - January 1, 2003 December 31, 2003 ITEM PEARSON CORRELATION SIGNIFICANCE LEVEL Canes/Walking Sticks Cutlery 0.05 Jewelry Toys/Children s Items Miscellaneous Apparel Not significant Specialty Items.078 Not significant All Items RESULTS AND LIMITATIONS Only a mild degree of significant price elasticity was observed among a majority number of the seven categories of merchandise consigned and demonstrated through a weak yet inverse correlation between the independent variable, quantities of merchandise consigned and the dependent variable, prices/bids received from consumers. Although the mild inverse relationship allowed for rejection of the Null Hypotheses, the expectation of a stronger inverse relationship was not realized. Furthermore, the mild relationship indicated provides support for the expectation of revenue equivalence rather than for the expectation of price fluctuation related to the traditional laws of supply and demand. Limitations of the results of this study include the use of only one case study or one year s data. In addition, the results of this study are based upon data collected for the last year of a ten-year summative evaluation of C.A.L.M., Consignment Auction Liquidation Marketing Method. Utilization of the entire data set for a ten-year period, 1993 through 2003, would provide for further opportunities to assess the correlation between the independent variable, quantities of merchandise consigned and the dependent variable, prices/bids received from consumers on a longitudinal basis. REFERENCES Alderson, W. (1954). Factors Governing the Development of Marketing Channels. Homewood, IL: Richard D. Irwin, Inc. Auction Advantage. (2008). Internet Auctions Are Drawing Bigger Crowds To Live Auctions. Vol. 5, Issue 2, page 3. Coverse, P. D. (1951). Development of Marketing Theory: Fifty Years of Progress. Urbana, IL: University of Illinois Press. Gallup Organization. (1993) National Auctioneers Association Market Research Report. Princeton, NJ: The Gallup Organization.

5 Hall, R. E. & Lieberman, M. (2003). Economics: Principles and Applications. (2 nd ed.). Mason, OH: Thomson Southwestern. Klemperer, P. (2004). Auctions: Theory and Practice. Oxford University, UK. Kotler, P. & Armstrong, G. (1996). Principles of Marketing. (7 th ed.). Englewood Cliffs, NJ: Prentice Hall. Milgram, P. R. & Weber, R. J. (1982). A Theory of Auctions and Competitive Bidding. Econometrica, Vol. 50, No. 5. Pride, M.W. & Ferrell, O.C. (2009). Foundations of Marketing (3 rd ed.) Boston, MA: Houghton Mifflin Company. Vickery, W. (1961). Counterspeculation, Auctions and Competitive Sealed Tenders, Journal of Finance. Walters, G. C. & Robin, D. P. (1978). Classics in Marketing. Santa Monica, CA: Goodyear Publishing Company, Inc. Wilner, L. L. (1996). The Uniform Commercial Code Legal Forms. (3 rd ed.). Clark, Boardman and Callaghan: Deerfield, IL.