Defaulting in Second-Price Auctions and the Bid-Cap Solution

Abstract: When auctioning pricey assets, sellers face a difficulty to ensure that the winners pay the agreed price. When public projects are at stake, this also poses a problem for a larger population. In theory and in practice, the phenomenon of defaulting in auctions is usually handled either through renegotiation or through penalties. In this paper, we propose a relatively novel method of addressing this issue through bid caps. Under some assumptions on the probability to default, we show that a bid cap, an upper bound on the bids imposed by the seller, increases the expected payoff of the seller, as well as the expected payoff of the bidders (a win-win situation). We also prove that there exists a wide range of possible caps that the seller can fix and still increase the expected payoff of all the parties involved.