What Is an Auction? Definition, How They Work, Pros, and Cons

What Is an Auction?

An auction is a sales event wherein potential buyers place competitive bids on assets or services either in an open or closed format. Auctions are popular because buyers and sellers believe they will get a good deal buying or selling assets.

How Auctions Work

In an open format, all bidders are aware of the bids submitted. In a closed format, bidders are not aware of other bids. Auctions can be live, or they can be conducted on an online platform. The asset or service in question is sold to the party that places the highest bid in an open auction and usually to the highest bidder in a closed auction.

Example of Auctions

Open Auctions

In an open auction, parties come together at a physical venue or online exchange to bid on assets. An interested party is aware of the competing bid amounts and continues to raise their bid until they are either declared the winner of the auction (i.e., they submitted the last highest bid within the auction time limit) or until they decide to drop out of the bidding.

Examples of auctions include livestock markets where farmers buy and sell animals, car auctions, or an auction room at Sotheby's or Christie's where collectors bid on works of art. Leading online marketplace eBay is a host of online auctions.

Closed Format Auctions

In many business transactions, including the sale of company assets or an entire company, auctions are conducted in a closed format whereby interested parties submit sealed bids to the seller. These bid amounts are only known by the seller. The seller may choose to hold just one round of bidding, or the seller may select two or more bidders for an additional auction round.

In a situation wherein a division of a company or the whole company is up for sale, price is not the only consideration. The seller, for example, may want to preserve as many jobs as possible for its employees. If a bidder does not submit the highest price but can offer the best terms for continuity for employees, the seller may select that bidder.

Government Auctions

Property may become government-owned property through normal purchases or if it is foreclosed on for any reason. Investors interested in land and other assets can attend an auction of government-owned property, which may ultimately be sold at attractive prices.

For example, suppose that a manufacturer declares bankruptcy. If the manufacturer also owes a substantial amount of taxes, the government may seize its capital equipment, including buildings, machinery, equipment, vehicles, and tools, and auction it off to other manufacturers. There is an incentive for other manufacturers to buy these capital goods at auction because they are able to pay less for the used equipment than they would if they purchased brand-new equipment.

Traditional Auctions vs. Dutch Auctions

A variant of the traditional auction is a dutch auction. Google (since renamed as Alphabet Inc.) used this process when it issued its initial public offering (IPO) in 2004. In this form of auction, prospective buyers submit bids including the number of shares desired and the amount they are willing to pay for those shares.

In the case of Google, after the auction, the underwriters sorted through the bids to determine the minimum bid they would accept from buyers. The IPO was priced at $85 per share.

A Dutch auction also refers to a type of auction whereby the price of an item is lowered until there is a bid. The first bid made is the winning bid and results in a sale, assuming that the price is above the reserve price. This is in contrast to typical options, where the price rises as bidders compete. Dutch auctions are rare in the pricing of IPOs.

How to Buy a House at an Auction

Most individuals who are interested in buying a property start by browsing online real estate listings or working with a real estate agent. However, there is a third option for those interested in purchasing a home: You can also purchase a property at an auction.

There are two ways that a home can end up being auctioned off: foreclosure or property tax default auctions. In the first scenario, a foreclosed home is auctioned because the homeowner has not paid the mortgage for at least a few months. After their mortgage falls into default, it may end up in foreclosure. The homeowner's lender can put the home up for auction and force the homeowner out for nonpayment. The home is then auctioned off by bank-hired trustees.

Similarly, a home may end up being auctioned if the homeowner does not pay the assessed property taxes. In this case, the unpaid tax authority rather than the bank seizes the property. The auction is conducted by a local sheriff, clerk, or the county or local tax authority’s comptroller’s office.

You can find home auctions through local governments, real estate agents, and various online sites. While there are significant risks to buying a home at auction, one of the potential benefits is that you may be able to purchase at a discount. You may also face less competition when buying a home at auction (versus buying a home in the traditional way).

Advantages and Disadvantages of Auctions

There are both advantages and disadvantages of auctions. Sometimes people can find rare items at auctions. And there is always the possibility that a buyer can purchase an item at a discount at an auction.

In the case of purchasing property through an auction, this process can deter some potential buyers because of its competitive nature.

When it is the sale of company assets or an entire company, there are many advantages for the seller because they control the entire auction process. They can create a competitive environment in order to maximize their bargaining power, and, ultimately, achieve a higher price.

On the other hand, the price of running an auction sale can be significant. The seller must have a strategy for the auction process, and this requires the service of both financial and legal advisers.

While securing a bargain is always a possibility, if there are multiple bidders, it is also possible that the buyer in an auction will actually pay more because of the potential competition of other bidders.