essays on the theory of auctions and economic rents

When competing in factor or product markets to acquire resources or sell goods, firms often have to make strategic decisions whether to use spot market transactions with posted prices, n

ESSAYS ON THE THEORY OF AUCTIONS

AND ECONOMIC RENTS

DISSERTATION Presented in Partial Fulfillment of the Requirements for The Degree Doctor of Philosophy in the Graduate

School of the Ohio State University

Professor Oded Shenkar, Adviser

Professor Jay Barney

Professor John Kagel

Professor Richard Makadok Business Administration Graduate Program Professor Konstantina Kiousis

Copyright by Ilgaz T Arikan

2004

ABSTRACT

Transaction cost economics focuses on when firms should buy resources, whereas resource based view focuses on what resources firms should buy This dissertation focuses on how firms should buy resources in factor markets to create competitive

advantages

In the first chapter, I model resource acquisition by operationalizing pricing as an endogenous component of competitive strategy and compare negotiation, auction and posted price mechanisms I identify 5 factors, which affect a firm's choice between each market mechanism Using a hypothetical entrepreneurial firm, I model the sale of a unique resource (a patent), and argue that the question of "how a firm should buy/sell resources" is critical for our understanding of firm competitiveness

In the second chapter, I apply the model predictions of my first essay to market for firms, and study how an entrepreneurial firm should be sold Using initial public offerings as auctions and mid-market mergers and acquisitions as negotiations, I examine the performance effects of the discrete choices entrepreneurial firms make when they sell their firm (e.g a bundle of resources)

In the third chapter, I study an application of the auction theory in practice and I investigate business-to-business online auctions and auctioneers, and their effects on firm

competitiveness using an in depth analysis of intermediary firms and exchange rules by analyzing 4 online auctioneers

In my dissertation I focus on how firms should buy resources in factor markets to

create competitive advantages When competing in factor or product markets to acquire resources or sell goods, firms often have to make strategic decisions whether to use spot market transactions with posted prices, negotiation markets with bargaining, or auction markets with bidding Given these three different market mechanisms, what are the firm and industry specific factors that determine different selling/buying devices to occur simultaneously in the market? By endogenizing pricing as a strategic variable, managers can choose among different market mechanisms in pursuit of rents In this paper I model dynamic resource acquisition in equilibrium, simultaneously taking into account the characteristics of factor markets from both the sellers' and the buyers' perspectives Auctions, negotiations and spot markets are compared given heterogeneity of

expectations, bargaining power of the participants, market thickness, risk propensity and search costs

I empirically investigate my thesis and find strong support for my predictions Based on the theoretical work by Campbell and Levin (2001) and Arikan (2002), I use predictions from the theory of auctions and negotiations to explain the optimal choice between market mechanisms in an entrepreneurial context Two major markets exist for the sale of an entrepreneurial firm: initial public offering (IPO) versus mergers and

acquisitions (M&A) markets This paper argues that choosing between these two market mechanisms is not serendipitous I argue that the discrete choice between choosing to auction off a company through an IPO or to negotiate its sale as a privately held target rests on five factors: bargaining power, resource value, market thickness, risk propensity and search costs Using a nested logit model, I test this general discrete choice using a sample of IPOs and M&As of privately held entrepreneurial firms between 1975-1999 I find that entrepreneurial firms strongly follow the theoretical predictions developed in Arikan (2002) All else being equal, entrepreneurial firms with high bargaining power are more likely to choose negotiations (M&A) versus auctions (IPO) Firms that represent high private values (e.g in high-tech industries) are more likely to be sold through

auctions versus negotiations As the market thickness increases, the likelihood of

entrepreneurial firms being sold through M&A decreases However, this finding is

reversed for firms with higher private values For firms with high debt ratios, the

likelihood of M&A increases compared to IPOs I find that as venture capital activity in the focal industry increases, the likelihood of M&As increases

I further investigated the use of auctions in buying and selling resources in the context of business-to-business online marketplaces I constructed a proprietary dataset consisting of major market makers and industry players that are involved in industrial parts and machinery trade I identified the different auction formats and rules, as well as the market structures

ACKNOWLEDGMENTS

I wish to thank my adviser Oded Shenkar, and my committee members Jay Barney, John Kagel, Karen Wruck, Konstantina Kiousis and Richard Makadok for their intellectual support, encouragement, and enthusiasm which made this thesis possible

I am grateful to Asli Arikan for her continued support and stimulating discussions

on all aspects of my research interests

I benefited a lot from discussions with Juan Alcacer, Adam Brandenburger, Colin Camerer, Russ Coff, Boris Groysberg, Florian Heiss, David Hirshleifer, Anne-Marie Knott, Josh Lerner, Dan Levin, Joe Mahoney, and Bernie Yeung for their helpful

comments and discussions All the errors remain mine

I also wish to thank Reed Foster at Ravenswood Winery, Richard Langdale at NCT Ventures and various analysts at W.R Hambrecht They gave me great many insights from practitioners’ perspective

I gratefully acknowledge financial support from the Center for International Business Studies Research and the OSURF both at the Ohio State University

VITA

May 5, 1971 ………Born – Manisa, Turkey

1994 ……….… BA/BS University of Marmara, Istanbul Turkey

1997 ……….….MBA University of North Carolina

2003-Current ……….Instructor, Boston University

PUBLICATIONS

Research Publication

Arikan, I (2003) “Exit decisions of entrepreneurial firms: IPOs versus M&As” In New

Venture Investment: Choices and Consequences, (Eds.) A Ginsberg, and I Hasan North-Holland,

Elsevier

Arikan, I., and Meredith, M (2003) “Doing Research in International Management: Use of

the Internet” In 2nd Edition of Handbook of International Management Research, (Eds.) B J

Punnett, and O Shenkar University of Michigan Press

FIELDS OF STUDY

Major Field: Business Administration

Minor Field: Economics

TABLE OF CONTENTS

Page

Abstract ii

Acknowledgments v

Vita vi

List of Tables ix

List of Figures xi

Chapters: 1 Introduction 1

2 Theoretical Background 4

2.1 How Do Managers Create Economic Rents? 8

2.2 Strategic Factor Markets 11

2.3 How Can Firms Create Market Imperfections? 13

2.4 Market Mechanisms For Resource Acquisition 14

2.5 Spot Markets And Posted Prices 16

2.6 Negotiation Markets And Bargaining 18

2.7 Auctions And Strategic Bidding 21

2.8 Comparing Market Mechanisms For Rent Generation 25

2.9 Discussion 32

3 Auctions Versus Negotiations 37

3.1 Market Mechanisms 39

3.2 Determinants Of Mechanism Choice 41

3.3 Ipos As Auctions 47

3.4 M&As As Negotiations 50

3.5 Empirical Analysis 55

3.5.1 Empirical Design 55

3.6 Data And Sample Description 56

3.7 Variables 59

3.7.1 Explanatory Variables 60

3.7.2 Control Variables 68

3.8 Statistical Method 70

3.9 Results 76

3.10 Discussion 85

4 Economic Rent Generation In Online Auctions 93

4.1 Auctions 96

4.2 Design And Conduct Of Auction Institutions 100

4.3 Business-To-Business (B2b) Online Auctions 101

4.4 Market Makers In Online Exchanges 104

4.5 Decision Making And Bidding Capability 112

4.5 Discussion 116

List of References 128

LIST OF TABLES

1 Market Mechanisms and Rents (Seller) 155

2 Market Mechanisms and Rents (Buyer) 156

3 Industry Classification - 2-Digit SIC Codes 157

4 Summary of Empirical Predictions for the Nested Model for the Choice of Auctions vs Negotiation 161

5 Number of Sellers for Mid-Market M&A Acquisitions 162

6 Average Ratio of Price Paid over Total Assets for Mid-Market M&A 163

7 Financial Information for Private Company IPOs 165

8 IPO issues by Private Firms 168

9 Manufacturing Sector by 2 Digit SIC Codes 169

10 Manufacturing Sector by Target Nation 170

11 Price Range for the IPO and M&A Deals 171

12 Descriptive Statistics 172

13 Logistic Regression of the Mechanism Choice (IPO=1, M&A=0) 173

14 Logit Model Coeff Estimates For The Choice of Auctions (IPOs) vs Not IPO* 174 15 Logit Model Coeff Estimates For the Choice of Auctions (IPOs) vs Negotiations (M&As) 175

16 Conditional Logistic Regression 176

17 Multinomial Logistic Regression 177

18 Nested Logit-Part 1 178

19 Nested Logit-Part 2 179

LIST OF FIGURES

1 Empirical Model of Auction-Negotiation Mechanism Choices 160

competitive advantages When competing in factor or product markets to acquire

resources or sell products, firms often have to make strategic decisions whether to use spot market transactions with posted prices, negotiation markets with bargaining, or auction markets with bidding Therefore I examine the conditions under which firms will prefer one market mechanism over another

In the strategy literature, two theories have sought to explain the heterogeneity in firm performance: structure-conduct-performance (SCP) paradigm based on industrial organization economics, and resource-based view (RBV) of the firm, based on a

combination of Penrosian economics, Austrian economics, and the evolutionary theory of the firm SCP researchers looked at product market competition and applied classical

industrial organization tools to explain firm performance differences and to utilize firms' strategic actions to command prices through gaining monopoly positions RBV studies focused on factor market dynamics but implicitly assumed firms had to take prices as given In the RBV literature, it is well established that when firms acquire rare, inimitable and valuable resources from factor markets they gain competitive advantage, and this

competitive advantage may be sustainable However, the mechanisms by which firms

acquire these resources have received little attention The purpose of this paper is to develop a general model of strategic factor markets and firm performance

How do firms outperform their rivals when acquiring scarce factors of production

in strategic factor markets? In this paper, using heterogeneity and imperfect mobility of resources, pricing is operationalized as a strategic variable that transforms price-taking firms into market makers In strategic factor markets, if markets are perfectly competitive and efficient, the information released among players will reflect the performance of those resources traded in the exchange Since markets will anticipate the value of these resources, their prices will be bid up, and the economics rents will dissipate In fact, if a firm's strategies result in imperfect product markets, these still cannot be a source of economic rents So how can firms create imperfections in resource markets? Firms can generate heterogeneous expectations about resources and create market imperfections by transforming themselves into market makers instead of price takers In this context, pricing mechanism becomes a strategic variable and can generate economic rents in factor markets Thus, market mechanisms such as auctions should be studied in a

comparative context to understand the dynamics of rent generation and appropriation in factor markets This chapter is organized as follows First, a theoretical background of

factor market economics is provided outlining the SCP, TCE, and RBV arguments Second, based on Barney (1986) and Peteraf (1993) a resource-based model of factor markets is presented Third, the basic tenets of three market mechanisms in relation to factor markets are introduced Specifically, spot markets and posted prices, negotiation markets with bargaining, and auctions with strategic bidding are modeled In the final section, these three market mechanisms are compared given a hypothetical case Managerial implications and extensions of optimal acquisition strategies are discussed

CHAPTER 2

THEORETICAL BACKGROUND

The traditional approach to resource acquisition has been various applications of the neoclassical economic theory of the firm, which treats firms as price takers In

competitive markets, firms operate in complete markets1 and perfectly competitive

equilibrium requires that rents converge to zero In strategic factor markets, if markets are perfectly competitive and efficient, information released among players will reflect the performance of those resources traded in the exchange Since markets will anticipate the value for these resources, their prices will be bid up, and economic rents will dissipate (Barney, 1986) In fact, if a firm's strategies result in imperfect product markets, these still cannot be a source of economic rents In strategic factor markets, rents are created through heterogeneous expectations Heterogeneous expectations are caused by mark

1 The central hypothesis of the Arrow-Debreu model is that there is a market for every good produced and consumed in every possible future contingency (Arrow, 1953; Debreu, 1959) In other words, there is a complete set of contingent markets, and if economic agents had full information of future events, and unlimited powers to compute benefits from all potential courses of action, and if the society could

effortlessly and costlessly monitor these actions and commitments, markets could efficiently allocate resources.

imperfections, and market imperfections are caused by information asymmetries Most of the theories in strategy implicitly assume that firms are price takers The main reason is the earlier dominance of product market strategies (Porter, 1980) RBV shifted the emphasis to strategic factor markets and resource immobility I argue that how parties exchange in factor markets (spot markets, negotiations, auctions) will have an impact on rent generation and appropriation

General equilibrium models describe a market economy for factors of production, capital goods, and money Originally developed by Walras (1874), later on modified by Pareto (1909), general equilibrium models developed first and second welfare theorems First welfare theorem argues for a ``Walrasian equilibrium'' that satisfies the same price ratio for all agents as well as the same marginal rates of substitution, which is a Pareto efficient allocation In other words, both agents (buyers and sellers) end up at the same allocation point when they maximize their preferences The second welfare theorem rules out the increasing returns to scale assumptions by arguing that firms are small relative to the market Hence, any Pareto allocation can be utilized by a market mechanism given a set of right prices and an appropriate redistribution of income among economic agents

Arrow (1951), and Debreu (1952, 1959) transformed this equilibrium into an axiomatic form with the following assumptions: there are no information asymmetries between agents, no agent can exert market power and firms are small relative to the market, there are no increasing returns to scale and competitive markets allocate

resources efficiently In Walrasian equilibrium, it is not clear “who” sets the prices, or

“how” the market operates Similarly “money” does not exist; prices are measured in

some numeraire Instead, there exists a “Walrasian auctioneer2”, a fairly unrealistic mechanism personified as an individual who stands in front of the markets and calls out prices, allowing agents to prefer and consume goods and resources (Kreps, 1990) This is

a continuous auction and at some efficient allocation point, all markets clear

Industrial Organization (IO) theory of the firm, relaxes the first welfare theorem assumptions, and the most important concern remains as the social planner's role to attain competitive equilibrium (Lippman and Rumelt, 1982) The nature of the goods can be either public or private, and externalities and informational asymmetries may exist among agents about products and resources These assumptions result in managers being strategy makers and strategic pricing of resources, and untruthful bidding govern exchanges An extension of these conditions results in incomplete contracts (Holmström and Tirole, 1987) Costs associated with such contracts are first discussed by Coase (1937) and developed by Williamson (1975) as transaction cost economics (TCE)

While TCE explains how firms choose similar governance mechanisms among various forms under similar economic situations, this only augments the homogeneity of firms (Barney and Hesterly, 1996), and does not explain why some firms outperform their rivals, and why they are different In RBV, a resource must be valuable, rare,

imperfectly imitable, and unsubstitutable to be a source of sustainable competitive

advantage (Barney, 1991) But, if all agents value the same resource the same way, and the performance of the same resource is identical among all interested parties, even

2 I would like to thank Axel Leijonhufvud who has coined the term for helpful insights He created this anthropomorphism in order to compare the Walrasian auctioneer to Maxwell’s demon in a paper entitled

“Keynes and the Keynesians: A Suggested Interpretation” in the American Economic Review, 1967

though the resource is valuable, rare, inimitable, and unsubstitutable, the bidding among the parties would drive the price of the resource high enough to erase economic rents In other words, if all agents have homogenous expectations about the productive capabilities

of a resource, its value would be common across bidders, and competitive bidding would drive up the prices, wasting economic rents during the process Therefore, unless a firm has a better use for the performance of a resource acquired in the factor market, it will overbid its value and be subject to winner's curse Winner's curse occurs when winning

bidders overestimate the true value of the item being traded (Levin et al., 1996; Kagel

and Levin, 1986) In formal auction theory, the price of a product reflects two values: common and private values (Milgrom, 1989)

Common value component of a product is unknown at the time of bidding, but in fact its value is predetermined, through a continuous demand-supply adjustment in the market Private value component is unique to each bidder and depends on each party's rent generation potential Since the potential rents are not identical, the winner is not subject to winner's curse, and cannot overbid its value in private value auctions The equilibrium prediction is that as public information about the value of the resource being auctioned increases, winning bids rise When there is more uncertainty about the value, bidders discount their private information Therefore in a market at equilibrium, when the uncertainty about the true value is reduced, agents discount their private information and cause winning bids to rise (Roth, 1995) Thus, I argue that firms that have generated heterogeneous expectations about a resource may create and appropriate economic rents through auctions

Even if factor markets are perfectly competitive, auction mechanisms can create Ricardian rents in equilibrium Perfect competition in factor markets require prices to reflect all information about the goods being traded Buyers are indifferent across product

choices given goods’ undifferentiated qualities Both sale and resale transactions are

conducted without costs3 Equilibrium in perfectly competitive markets is attained when for a given price, all goods being offered are consumed, the producers maximize profits, and there is no unfulfilled demand (Arrow and Debreu, 1954) Under such conditions, the economic rents generated through auctions can only result from efficiency and

productivity differences among factors of production If the productivity of these

resources were known, this information would be reflected in their prices However, if the acquirer has a heterogeneous expectation about the productivity of the resource, Ricardian rents can be generated In this sense, pricing becomes a strategic variable and transforms price-taking firms into market makers

Proposition 1: In perfectly competitive factor markets, auction mechanisms can create Ricardian rents in equilibrium

2.1 How Do Managers4 Create Economic Rents?

In the resource based view literature, two mechanisms have been proposed to explain how managers generate economic rents: resource selection, and capability

building Resource selection is a Ricardian perspective where the productivity of

resources are heterogeneously distributed among firms (Peteraf, 1993; Wernerfelt, 1984), and managers outsmart the factor markets by selecting resources based on their future values (Barney, 1986) The alternative Schumpeterian perspective is capability building,

a mechanism that depends on the deployment of resources to affect a desired end (Amit and Schoemaker, 1993; Mahoney, 1995) While capability building requires managers to develop a capacity to manage firm-specific tangible and intangible processes, the

resource selection mechanism demands managers to accurately assess expectations about the future value of resources

One argument is that when resources are selected, economic rents are created before the firm acquires those resources, and after if the firm develops capabilities based

on firm specific processes The distinctions between these two mechanisms have

important theoretical, empirical and practical implications (Makadok, 2001) Makadok assumes that rents are embedded on a resource, and existence of rents triggers firms' to select or pick this resource Furthermore, due to the common value characteristics of the resource, the bidding process dissipates rents On the other hand, the capability building approach is more in line with creation of private values for a resource, since the

developed resource is more firm specific; hence, rents that are created are harder to bid

above normal returns Similarly, if all rents were embedded in internally developed capabilities, then, these firm specific assets would have a very low common value when traded or transferred, resulting in no rent appropriation The question then becomes: Under what conditions will these two mechanisms be preferred to each other? And why are some firms better at picking resources versus some other that are good in developing capabilities?

Some empirical and practical cases display the characteristics of one mechanism dominating over the other For example in the market for firms, mergers and acquisition

activities require managers to value tangible and intangible assets of targets (Hitt et al.,

1990) It can be argued that tangible assets are easier to value due to their common value characteristics, and intangible assets being assessed more subjectively due to their private value components5 When managers overestimate the productivity of these assets, they are subject to winner’s curse (Arikan, 2002) On the other hand, research and

development firms might find it more advantageous to develop capabilities internally

(Hitt et al., 1991)

If strategic factor markets are perfectly competitive, the acquisition of resources

in those markets will anticipate the performance those resources will create when used to implement product market strategies Therefore, even if firms are successful in creating imperfectly competitive product markets, those resources cannot be a source of economic

5 For example, let us assume that a firm acquires a metal stamping plant The productivity of stamping machines may be well established based on technical aspects of the machinery, their working conditions, etc On the other hand, it is somewhat more difficult to establish the productivity of the engineering capability embedded in the firm

rents (Barney and Arikan, 2001) How can managers create imperfections in strategic factor markets? Two ways are suggested: first, firms can be lucky in the face of

uncertainty, and second, firms can have unusual insights about the future value of a resource (Barney, 1986; Demsetz, 1973) The role of managers is to coordinate the use of productive resources and entrepreneurial skills (Penrose, 1959) While luck cannot be a systematic source of competitive advantage, developing a productive skill set to assess expectations and valuations about a resource can be repeated Such a skill set may be inimitable, rare and valuable, non-substitutable and therefore create rents While it is clear that according to resource selection model economic rents are created before firms acquire these resources in strategic factor markets, it is not clear how firms acquire these resources, and whether the mechanism by which those resources are acquired would affect rents

2.2 Strategic Factor Markets

A strategic factor market is a market where the resources necessary to implement

a strategy are acquired (Barney, 1986) The economic foundations of RBV strongly rest

on several early contributions on the dynamics of competition on product and resource markets by firms (Wernerfelt, 1984), and on the ability of firms to generate and

appropriate economic rents (Rumelt, 1984) Differences between firms are in the relative efficiency by which they extract and process homogeneous goods This in fact results in the birth of the ``strategic firm,'' which can be characterized ``by a bundle of linked and idiosyncratic resources and resource conversion activities'' (Rumelt, 1987) These early

contributions explained the dynamics of entrepreneurial activities, market entry and exit, economic rent generation and appropriation through the processes of isolation, variation and selection (Rumelt, 1997) Rumelt identified sources of rents and isolating

mechanisms, which help explain heterogeneity in an equilibrium framework By

definition, economic rents are payments to owners of a factor of production in excess of the minimum required to induce that factor into employment (Hirshleifer, 1980) The major influence on the evolution of the RBV came from Ricardian Economics (Barney and Arikan, 2001) Although Ricardian rents were paid off to those that owned higher-quality factors of production with inelastic supply and left little or no role for managers, firms that own such resources may be able to earn economic rents by exploiting them (Barney and Arikan, 2001)

The mechanisms by which firms acquire or develop these resources in efforts to create heterogeneity are seminal in strategic factor markets theory (Barney, 1986) The concept of a strategic factor market is probably the very essence of the RBV, especially

in terms of rent generation and earning above normal firm performance arguments “If strategic factor markets are perfectly competitive, the acquisition of resources in those markets will anticipate the performance those resources will create when used to

implement product market strategies.” This suggests that, if strategic factor markets are perfectly competitive, even if firms are successful in implementing strategies that can create imperfectly competitive product markets, those strategies will not be a source of economic rents'' (Barney and Arikan, 2001) The economic insight in creation of

imperfection in factor markets follows Demsetz (1973): firms being lucky, and firms having unusual insight about the future value of a resource A general model of resources

and firm performance in the context of competitive advantage in RBV was later on developed by Peteraf (1993) who argued for four conditions: resource heterogeneity, ex post limits to competition, imperfect resource mobility, and ex ante limits to competition These four “cornerstones” are critical for the generation and appropriation of Ricardian or monopoly rents

2.3 How Can Firms Create Market Imperfections?

The potential for rent generation in factor markets are based on two assumptions: resource heterogeneity (Barney, 1991), and resource immobility (Dierickx and Cool, 1989; Peteraf, 1993; Rumelt, 1987) These two assumptions are firmly established in the RBV literature for the existence of economic rents (Barney and Arikan, 2001) Resource heterogeneity ensures that productive factors have intrinsically differential levels of

“efficiency”, which may result in Ricardian rents (Peteraf, 1993) What results in

efficiency based rents is the scarcity of these superior resources If the availability of resources were not limited, rents would dissipate and homogeneous producers would earn normal returns Heterogeneity arguments are also consistent with monopoly rents where homogeneous firms can earn above normal returns when they display Cournot

competition (Caves and Porter, 1977) Imperfect mobility of resources is linked to firm specificity of productive factors Both TCE and RBV explanations augment this

condition, and because imperfectly mobile resources have lower value to other users, the economic rents cannot be bid away by competitors

Therefore, resources that are immobile, by definition are context specific, and cannot have economic rents embedded on themselves When firms acquire such

resources, rents are created ex post Based on the resource heterogeneity and imperfect mobility of resources assumptions, the potential for rents arises However, prices for

these resources are assumed to be given by the market, and mechanisms by which firms

acquire these resources are not discussed This paper addresses this gap in the RBV literature by developing a framework for valuation and acquisition of resources in

strategic factor markets A formal model of resource pricing is proposed for resource acquisition mechanisms The assumption that firms are price takers in perfect competition suggests that the pricing mechanism is not important because it is either exogenous and instantaneous, or endogenous but equifinal However, in factor market arguments we require that firms buy resources in imperfectly competitive markets by luck or by

heterogeneous expectations (Peteraf, 1993)

Proposition 2: If firms have heterogeneous expectations of a particular resource, then they may use pricing mechanisms to create competitive advantage

Proposition 3: Resource immobility creates market imperfections for firms with

heterogeneous expectations of a particular resource and allow differences in rent

generation by using various market mechanisms

2.4 Market Mechanisms for Resource Acquisition

Broadly speaking, there are three market mechanisms: spot market transactions at posted prices, negotiation markets with bargaining (bilateral or multilateral), and auction markets with strategic bidding In the RBV literature, although not explicitly discussed,

spot market transactions at fixed prices are assumed.6 However, at the core of strategic factor markets theory, there is an implied common value auction mechanism illustrating the conditions under which rents dissipate rather than being created “In the long run, firms with more accurate expectations will usually be able to avoid economic losses associated with buying overpriced strategic resources Firms that do acquire these

overpriced resources suffer from the ‘winner’s curse,’ that is, the fact that they

successfully acquire the resources in question suggests that they overbid” (Barney, 1986: 1233) This argument asserts that the value of the resource is, or will be, the same to all bidders after the acquisition Hence, if there is a winner, then it is most likely the case that she has paid too much In other words, assuming the markets are efficient, through her bidding all rents would be dissipated This is probably one of the most interesting

issues in strategic factor market thinking In this sense, the emphasis is not on what resource a firm buys, but how it buys that particular resource

We have to think of the pricing mechanism as an endogenous component of firms’ competitive strategy Given three different market mechanisms, the relevant question becomes: what determines different selling/buying devices to occur

simultaneously in the market? In the next section, I will briefly discuss these market mechanisms

6 There are several recent exceptions such as Makadok, 2001, and Makadok and Barney, 2001 In these two studies, auction markets are utilized in factor markets

2.5 Spot Markets and Posted Prices

Posted price mechanisms allow for market exchanges of immediately delivered commodities between consumers and producers without negotiations Neoclassical economic theory defines two entities party to a market exchange: firms and consumers A firm has an objective and profit function that it maximizes, given resource and budget constraints Similarly, a consumer has an objective and utility function, which she also maximizes given a different set of resource and budget constraints These are known as technological and market constraints Technological constraints affect production

functions, and market constraints affect prices (Varian, 1992) These neoclassical models

of spot exchanges between firms and consumers are also extended to exchanges between firms

When there are many sellers of a homogeneous good and many well-informed buyers who can costlessly search and acquire resources, we have perfectly competitive markets Buyers and sellers are fully informed about each others’ preferences, prices and

utilities, and entry and exit is unconstrained (Baumol et al., 1982) The prices are set to

be fixed, and in this sense consumers, suppliers and firms are price takers The market clearing prices that are set by the continuous auctioning action of the Walrasian

auctioneer, allow the customer to buy a certain amount of the homogeneous good If the

prices were any higher than what is known to be the market clearing level, there would be

no transaction Similarly, if the products were at all diversified, then customers would have an incentive to compare quality, price and features of these resources

If factor markets displayed a frictionless Walrasian framework, and firms did not have to search for resources, all transactions would be conducted in spot markets, and economic rents could not be generated from the acquisition function (or from resource selection alone) In such factor markets, any other market mechanism would introduce inefficiency due to high search and coordination costs Since the inputs of one market is most often the outputs of another, symmetry would also hold for product markets and product market competition Under such conditions, the only way to generate economic

rents would be linked to a process of input to output conversion, consistent with the black

box characterization of firms (and this is similar to capability building)

For a firm, the simplest kind of market behavior is the price taking behavior, and perfectly competitive firms are assumed to be price takers This approach naturally assumes the homogeneity of prices, firms, and managers When resources and products are standardized and market clearing prices are stable, posted price markets work highly efficiently (Milgrom, 1989) When information costs are low, and long-term

commitments and contractual relations are not required, spot market transactions can be optimal (Alchian and Demsetz, 1972) Price setting in neoclassical economics is through

the Walrasian auctioneer He sends out price signals, pˆ and prices adjust depending on

demand D ( p) and supply S ( p) After these adjustments, the market price w p

equates supply and demand Q w =S( )p w = D( )p w , where Q w is the market clearing quantity

In order for markets to clear, and the law of one price to hold, the above

mentioned extreme conditions must be met But most resources are not homogeneous and

search is costly both in terms of actual costs associated with locating appropriate

resources, and in terms of opportunity costs associated with foregone opportunities Moreover, trade frictions give firms various degrees of market power, and one party often has an advantage over the other This advantage could be based on information

asymmetries, differences between firm specific resources and capabilities, or result strictly from coordination problems between firms In such markets, market makers are needed to act as intermediaries7 to coordinate transactions and clear markets (Spulber, 1996a, 1996b) Because search is costly and less efficient for individual buyers,

intermediaries may specialize in various resource searches, and provide expertise (Stigler, 1961)

Proposition 4: In factor markets with high search costs, heterogeneous valuations and information asymmetries, firms looking for resources conduct their exchanges through intermediaries

Proposition 5: The use of intermediaries allows firms to extract and appropriate some of the rents that would otherwise go to costly search activities

2.6 Negotiation Markets and Bargaining

Negotiation markets are best described by the actions of economic players

committing themselves voluntarily to various courses to resolve conflicts (Roth, 1977; Rubinstein, 1982) Ultimately, situations in which each party is guided mainly by his

7 Intermediaries are negotiators who receive no utility from consuming the good they trade Their incentive

is to generate arbitrage by decreasing search costs and risks associated with goods having unknown quality The arbitrage return intermediaries receive is the price they charge for reducing the adverse selection problem For a detailed review of the role of intermediaries in search and bilateral bargaining, please refer

to Rubinstein and Wolinsky (1987), and Biglaiser (1993)

expectations of what the other will accept constitute elements for pure bargaining

Because each party knows the other has expectations, expectations get compounded, and

a “bargain is struck when somebody makes a final concession” (Schelling, 1956)

Firms negotiate to create an opportunity for the involved parties to collaborate for mutual benefit in more than one way, given that the actions taken by individuals cannot affect the well being of the opposing parties without their consent (Nash, 1950) The possible solutions to such games consist of allocations that are Pareto efficient and that

do not make either of the parties worse off from what is consensually agreed (Arrow and Hahn, 1971) Generally, bargaining under symmetric information results in efficient outcomes, whereas information asymmetries might result in ex post trade inefficiencies (Coase, 1960) Information asymmetries give incentives to the parties to contract ex ante

to avoid or limit these inefficiencies (Tirole, 1988) and the contracting dynamics depend

on the ex ante relative bargaining power of the competitors (Williamson, 1975)

Bargaining power is the power to bind an opponent This suggests that an advantage can

be gained by accumulating some features, that the opponent does not have access to (Schelling, 1956) These advantages can vary from what a negotiator might have or manipulate, to the power to fool and bluff (Morgan, 1949) Given a range of

indeterminate but all possible solutions, when the cost of disagreement is the deciding factor, the bargaining power of the party with less cost is high (Hicks, 1932; Pigou, 1932)

Simplest form of negotiations can be represented as bilateral bargaining models

where two economic agents try to allocate a surplus between them Many bilateral

bargaining models have been developed and applied to various situations such as labor unions versus management, criminals versus district attorneys, etc (Horn and Wolinsky, 1988) In many ways, it is possible to argue that bilateral bargaining is the most basic form of exchange Expanding on this basic form, negotiations involving more than two agents (multilateral bargaining) can be developed based on the same principle: the

division of a surplus common to all parties to an exchange (Krishna and Serrano, 1996)

In negotiation markets, the market-clearing price p c is dependent on the utility

of feasible allocations for parties to the exchange8 If agent i faces all feasible

allocations with utility u , i [i=(1, ,n)] the equilibrium would be set at ,u where i′ u i′

would be preferable to all other u Assuming a rational individual will not accept a i

bargain with a better c i,

i

c u p u

p ′ f the alternative will be the Pareto optimal allocation,

and the equilibrium would be ( )′

i

c u

p , Given these, can negotiations repair

externalities? Put it in another way; are negotiations efficient ways of transacting? Coase (1960) claimed that if the market outcome is inefficient, then people would get together and negotiate their way to efficiency

8 We can substitute P i with Πi and make the same argument for a firm That is, instead of an agent negotiating for a preferable and feasible allocation that will maximize her utility, a manager will negotiate a preferable and feasible allocation that will maximize firm's profits

If the posted prices do not exist, and if voluntary negotiation cannot lead to fully efficient outcomes9, can the markets still complete the exchange through a market

mechanism? I argue that auctions and strategic bidding help solve these before mentioned inefficiencies under certain conditions These conditions are strongly affected by the bargaining power of the parties to an exchange Heterogeneous expectations and resource immobility would also affect the choice between negotiations versus auctions

2.7 Auctions and Strategic Bidding

Auctions can be broadly defined as any competition over a resource with a

deadline and clear rules Changing the rules of competition determines what type of auction is in place, and firms bid their valuations to acquire the item There are close analogies between auction theory, negotiation markets, and price theory of market

exchanges (Bulow and Klemperer, 1996) For example in an English auction where bidders increase their bids until one buyer remains and the seller is required to accept the bid, the sale price equals the lowest competitive price at which supply equals demand

Similarly, in auction markets the seller is treated as a monopolist who determines the minimum sale price and the rules, in order to maximize her revenues This assigns all bargaining power to the seller The argument can easily be extended to games with

multiple players, covering a variety of market-clearing resource allocations and prices Since these market players conduct exchanges without using posted prices, they are called ‘price makers’, and can be viewed as players in noncooperative games (Marschak and Selten, 1978) Auctions have three components: information structures of the parties, institutional mechanisms (rules) that govern the exchange, and risk preferences of the parties

Informational structure rests strongly on the efficiency of prices to communicate information If markets could effectively transmit information, the market design would not matter; the markets could solve the problem of externalities, adverse selection would disappear, and managers would not have to worry about selecting resources10 But

markets are rarely efficient in transmitting information, at least for brief periods Hence, the information structure of markets have a direct effect on managers’ risk preferences11

Auction theory provides explicit models for price formation and by eliminating the negotiation component, allows the competitive equilibrium be reached more

efficiently For example the trading floors of stock exchanges and commodity exchanges characterize open outcry markets In ascending auctions, competition among buyers forces the bids upward until a contract occurs The rules governing sellers is symmetric to

10 Hayek (1945) argued for such an efficient mechanism, which was later on developed by Arrow (1959) Both models would fail to explain Akerlof’s (1970) lemons market where private information caused market failures

11 Due to page limitations, I will not include risk aversion-neutrality arguments Please refer to Kahneman and Lovallo (1993) for a detailed review

that of buyers, and with the descending auctions The markets converge to the

competitive equilibrium even with very few traders (Smith, 1962; 1965) The direction of convergence to equilibrium reveals important insights for economic rent generation and appropriation12

In strategic factor markets, managers who can form accurate expectations about the firm-specific value of resources can create economic rents Such valuations are

dependent on three factors: pre-existing stocks of resources, information gathering

capability and information processing capability (Makadok and Barney, 2001; Barney and Arikan, 2001) In addition to these three factors, managers must choose among

market mechanisms for exchanges (spot market, negotiation, and auction), which in turn also affects their initial expectations

The second component in auctions is institutions that set the rules to govern

exchanges There are many types of auctions based on a variety of bidding rules

(Cassady, 1967) These can be grouped under four broad categories: the English auction (also called the oral, open, or ascending-bid auction); the Dutch (or descending bid) auction; the first-price sealed-bid auction; and the second-price sealed-bid (or Vickrey) auction (McAfee and McMillan, 1987) After a manager chooses auctions as a market

12 Some general empirical properties are known, especially in financial markets However, a compelling theory of dynamic adjustment does not exist While it is observed that markets converge almost instantaneously, the influence of basic economic conditions on adjustment paths are yet to be explored to provide generalizations For detailed discussions, please refer to Easley and Ledyard (1992), and Friedman (1984)

mechanism, then she is faced with a second question: what type of auctions best suit the firm characteristics, and conditions of the factor markets? This is especially important since different auction designs will not yield same expected revenues and economic rents (Kagel and Levin, 1993; Levin et al., 1996)

Finally, risk preferences of both the seller and the buyer play a crucial role in resource valuation13 There are two extreme cases: the private values model, and the common values model In private values model, bidder i knows her value exactly, and

she draws other bidders' (and seller's) value from some probability distribution function

observe all the bidders given the distribution F Most often items purchased for own i

use and not for resale such as antiques, resources acquired through internal development, rare and inimitable items fit this description The common values model is when the value of the item is same to every bidder ex post, but unknown at the time of bidding

(Wilson, 1977) If V is the unobserved true value, each v would be drawn from a i

distribution H known to all bidders, that is H(v i|V) , and bidders get signals from the

market to estimate the value Since the signals differ among individuals based on their

13 Bidders and sellers are assumed to be either risk neutral or risk averse individuals Each bidder is assumed

to know the number of bidders, their risk attitudes, and the probability distributions of valuations, and everyone knows that each other knows this, and so on In other words, it is assumed that bidders' subjective beliefs about unknown parameters are mutually consistent (Harsanyi, 1968) Arguments on overconfidence (Camerer, 1997) and bounded rationality (Conlisk, 1996) in auctions are omitted here for the sake of brevity

risk preferences in common value auctions, it is especially useful to know the other

bidders' valuation and preferences (Milgrom and Weber, 1982)

Proposition 6: Sellers with no bargaining power are better off using auction mechanisms

to compete in strategic factor markets with sellers who have market power when quality, quantity, or prices are concerned

Proposition 7: Sellers with some degree of market power are better off negotiating

contracts versus selling at posted market prices

2.8 Comparing Market Mechanisms for Rent Generation

Let us consider an entrepreneurial firm selling a new resource such as a new technology, a process, or a prototype where n risk neutral firms would be interested in acquiring it14 Bidders' signals x are identically independently distributed, i

)

(

,

~iid F •

x i on [ ]0,1 Any bid b that is at least as high as the reservation price i b ∗

of the seller is acceptable, b i ≥bmin ≥b∗ , and bids are a vector of prices The

entrepreneurial firm is faced with three alternatives First, it can sell the resource

(technology, process, or prototype) to an interested firm through bilateral negotiations,

14 Due to symmetry, I will focus on one risk neutral bidder without loss of generality Also for simplicity, the resource put on the market is assumed to be a single, indivisible item There is an important distinction between n bidders in auctions and n competitors in posted price markets As the number n in auctions increase, the market dynamics approach to the competitive market conditions If one were to correlate the number of bidders in common and private value auctions, the number of bidders would be positively correlated with common value components, and negatively correlated with private value components of resources For example, a 1931 Bugatti Type 41 Royale Coupe was sold in 2001 for $17 Million, and the auctioneer had sent out 100 brochures to potential buyers Conversely, a 2000-2001 model Chevy Cavalier (or a fleet of them) would not be sold at an auction, but its posted price would be equal to a common value auction price with relatively infinite number of buyers

hence it can be acquired If there are more than one potential clients, the entrepreneurial

firm can bid potential acquirers against each other in multilateral negotiations Second, the firm can sell this unique resource through an auction, by setting up clear rules and a time limit for the exchange15 Finally, the firm could establish a price for the value of the resource, and announce it was for sale The question therefore becomes, under what conditions should the entrepreneur choose among auctions, posted prices, and

negotiations in order to generate and appropriate economic rents?

First, let us consider the auctioning of this resource Assuming a Bayes-Nash equilibrium exists, every bidder bids as a function of x , and the derivative is strictly i

larger than zero:

0)(.)()(,0)

= ∫∗For the bidder, the tension is about her value and the potential profits she will gain from the auction The profit margin would be dependent on the probability of winning the auction Conceptually, the expected gain to the buyer is equal to reservation value times the probability of winning minus expected payments (Riley and Samuelson, 1981) In this auction setup, the seller would have to pay to get information about the bidder's

15 If the resource were to be the firm itself, it would put itself on the auction block, and conduct an IPO

valuation Maximizing with respect to b would give us the optimal reservation price as ∗

)(1

0)()1)()((

0)

()1)()((max

1

1 1

b f

b F b

b F b

F b f b n

dv v F v F v vf n

n

n b

b

In the first-price private value auctions, economic rents would equal to the

difference between the winner's true value, and the highest bid The bidder maximizes

[F σ B n− 1 x−B 16 If the design is second price ascending auction, the winning bid

would be b∗ =b i +δ =v , and the highest bidder would pay the second highest price, and the dominant strategy would be to bid your true value v (Vickrey, 1961)

If the resource in question had an equal probability of generating the same

economic rents for all firms interested in acquiring it, the valuation of this resource would change from private values to common values In common value auctions, the conceptual representation of the bidder's expected payoff in an auction is πe = (expected gain - expected payment) x probability of winning The surplus would be s i = /v i n−c i where

16 Assuming a symmetric solution, and we take the derivative of the profit function in equilibrium from an exogenous value ( x ) All derivations are omitted for the sake of brevity, and are available from the author upon request

v is the common value signal, there are n bidders, the bidder's surplus is s , and the

cost of acquiring the resource is c In common value auctions, as the number of bidders i

n approaches infinity, s i = , auction outcomes are going to be equal to posted price c i

outcomes in spot markets In an English auction, the equilibrium would be:

),

|(

),

rent Similarly, in a Vickrey auction, E(V −c i |s i =x,y i =x) the equilibrium point would be the dominant strategy for the private value second-price auction

So far, the above specified models assumed pure common values versus pure private values However in practice it is very rare that firms be in a position to acquire such ‘pure value’ resources In fact, resources will have both common and private value components, and a dominant strategy may no longer exist Instead, firms would have to look for optimal strategies to bid according to their expected values While in common value auctions overbidding one’s true value results in negative rents due to winner’s curse, firms with more accurate expectations than other firms about a resource's future value, will generate rents through auctions On the other hand, in posted price markets, the firm pays the same price as all the other firms that acquire the resource with

inaccurate valuations Resources that have uniformly steeper marginal revenue curves