Problems With a Reverse Dutch Auction

Problems With a Reverse Dutch Auction
••• Rawpixel/iStock/GettyImages

A reverse Dutch auction is the opposite of a conventional auction, as potential sellers make the bid rather than buyers. The price starts low and ratchets up until a seller agrees to bid on that price. Some people love reverse Dutch auctions for their speed and transparency. Others say they encourage artificially low pricing and a race to the bottom.

Understanding a Dutch Auction

Dutch auctions were invented in the 1600s to speed up the sale of flowers in Amsterdam. Tulips were a popular commodity at the time, and there were far more buyers than there were flowers for sale. To streamline trades, would-be buyers would gather in a room that contained a price clock. The price was set artificially high so no buyer was interested but over time, it would tick downwards. When the clock reached an acceptable number, a buyer would "stop the clock" and place an order for as many flowers as he wanted at that price.

Modern Dutch auctions have the same key attributes as those early tulip auctions. They occur when there are many buyers and one seller in the market. The price starts out artificially high, at a point where demand is believed to be zero. At specific intervals, the price is downgraded, and continues to tick down in increments until a buyer is lured into making a bid. The auction stops when the first bid is placed. The winning bidder gets his goods at the price listed when he stopped the clock.

What Is a Reverse Dutch Auction?

A reverse Dutch auction is the exact opposite of a Dutch auction, almost like a mirror image. Here, there is one buyer and many sellers in the market. The price starts out artificially low, such that no reasonable seller would agree to sell his goods at that price point. At specific intervals, the price ticks up in increments until a seller agrees to sell at the stated price. The buyer can also set a reserve price, called a ceiling, which is the maximum he will agree to pay for a quantity of product.

What's striking about a reverse Dutch auction is that the traditional roles of seller and buyer are reversed. It's the sellers not the buyers who are competing to win business, and this tends to keep prices very low.

Who Uses Reverse Dutch Auctions?

Lots of people use reverse auctions, but these are not the same as reverse Dutch auctions. With a straight reverse auction, the buyer puts out a call for goods or services, and the sellers then offer their best deals at the lowest price. The sellers are attempting to underbid each other, but there's no public ticking of the price clock. In fact, a reverse auction is not really an auction at all, but a forum where buyers indicate their requests and sellers make their offers.

An open procurement process is a type of straight reverse auction. For instance, whenever a government agency puts out a call for tenders, it essentially is asking suppliers (sellers) to put out their best and lowest bid. The buyer invites the offers, but he does not set or adjust the target price.

For an example of a true reverse Dutch auction, consider what happens when an airline overbooks a flight. Here, the airline (the buyer) might offer compensation to any passenger who is willing to change her travel plans. The compensatory price starts low and rises until someone raises her hand to stop the auction. The passenger may be willing to give up her seat for $50, $100, or $500 – the price is not established until the auction is stopped.

Advantages of Reverse Dutch Auction Strategy

While it's possible to hold a blind Dutch auction, which operates like a sealed-bid auction, most times, the auction price ticks up publicly so there's real-time transparency built into the process. The process is fair since every seller has a level playing field for placing bids. Ascending prices means that sellers will bid promptly when their internal price is reached so both parties get a clear result, quicker. The auction aspect achieves dramatic time savings through a reduced negotiation phase.

Nonetheless, reverse Dutch auctions are not without criticisms. There are some key problems associated with reverse Dutch auctions.

Problem: Race to the Bottom

With a reverse Dutch auction, the buyer sets an aggressively low price that he gradually raises until a seller calls "mine" and wins the bid. The longer the seller waits, the better the price he'll achieve. At the same time, there is a lot of competition in the room and thus an increased risk that another seller will preempt him.

In _theor_y a seller can stick to the price he would have offered in a sealed-bid auction. But in practice, a seller may crumble and bid early, at a lower price than he planned, to beat the competition.

The main problem here is supply and demand are woefully out of balance in a reverse Dutch auction and this results in lower dollar earnings for the seller. Many critics see reverse Dutch auctions as sticks with which to beat sellers to keep prices unrealistically low.

Problem: No Chance to Reconsider or Respond

The decision-making pressure on sellers is incredibly high at a reverse Dutch auction. Unlike with conventional auction bidding whereby the price ratchets upwards until there's one bidder left in the room, the sellers at a reverse Dutch auction cannot respond to competing bids. There are no bidding wars, just a one-time, stop-the-clock opportunity to win the bid.

Sellers must react quickly in deciding whether to place a bid or pass on a bid at a certain price. There's no time for reconsideration if it turns out the bid is too low, or if someone else sneaks in at a certain price point.

Problem: the Potential for Manipulation

Since everyone knows the price that's being offered, all the sellers know what the other sellers are willing to sell their products for. Sellers who frequently participate in reverse Dutch auctions can use this knowledge to anticipate another bidder's strategy and use it to his advantage. The real losers here are the first-time sellers who have no information regarding their competitors' minimum prices or their reverse Dutch auction strategies.

Problem: Poor Trading Relationships

A reverse Dutch auction is won solely on the basis of price, and this may not be the best way to measure a long-term supplier relationship. Consider a reverse Dutch auction tender offer for a five-year supply contract, for example. The winning bidder is the lowest bidder, and this person may not necessarily be offering the best quality, value for money, expertise, customization or other factors that could enhance the trading relationship. There is a risk of unqualified sellers entering a bid at an extremely low rate to drive market behavior.

These auctions have the potential to undermine relationships between buyers and suppliers. Sellers can feel exploited by the process, and buyers have no chance to swap to another supplier if there are quality or other issues with the winning bid. These features can damage future business relationships and ultimately harm the financial performance of both buyer and seller.