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

What Is an Auction?

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

How Auctions Work

An auction involves various people declaring financial amounts that they are willing to pay for an item that's been made available for purchase.

Auctions are conducted in person at some venue or virtually 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.

Types of Auctions

Open Auctions

In an open auction, parties come together at a physical location or an 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 drop out of the bidding.

Examples of open 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 Auctions

In many business transactions, including the sale of company assets or an entire company, auctions are conducted in a closed format. That means interested parties submit sealed bids and those bid amounts are known only to the seller.

The seller may choose to hold just one round of bidding or select two or more bidders for an additional auction round.

In a situation in which a division of a company or an entire company is up for sale, price is not the seller's only consideration. For example, the seller may want to preserve as many employee jobs as possible. 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 as a normal purchase or if it is foreclosed on for some 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. Though Dutch auctions are rare in the pricing of IPOs, Google (now known as Alphabet Inc.) used this process when it had 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 auctions, where the price rises as bidders compete.

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: You can purchase a property at an auction.

A home can end up being auctioned off as a foreclosure property or due to property tax default. 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 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 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 make a purchase at a significant discount. 

You may also face less competition when buying a home at auction compared to buying a home in the traditional way.

Advantages and Disadvantages of Auctions

Advantages

• Sometimes people can find rare items at auctions.
• Buyers can purchase an item for less than it might be priced elsewhere.
  
• A seller of company assets or an entire company can control the auction process. They can create a competitive environment to maximize their bargaining power, and, ultimately, achieve a higher price.

Disadvantages

• Some buyers may avoid purchasing property through an auction because of an auction's competitive nature.
• The price of running an auction sale can be significant. The seller must have a strategy for the auction process, and this requires the services and payment of both financial and legal advisers.
• While securing a bargain is always a possibility, if there are multiple bidders, a buyer may actually pay more than normal because of the potential competition driving the price up.

The Bottom Line

An auction is an event in which a seller puts an item up for sale and multiple buyers compete to purchase it by offering varying financial amounts. Usually, the highest amount, or bid, wins.

There are a variety of auction types, such as open auctions where all bids are visible, closed auctions where bids are kept private, and government auctions of seized property,

In an auction, a buyer may find rare items. They may be able to make purchases at lower than expected prices. Auctions may deliver to sellers a potentially large pool of interested buyers. On the other hand, auctions can turn off some buyers due to their competitive nature. And costs for sellers can be significant.