Thursday, December 8, 2011

Penny Auctions: Legalities and Realities

Penny auction sites are popping up everywhere on the Internet, like mushrooms after a storm. You've seen their ubiquitous banner ads, perhaps without knowing what they are: 95% off Apple iPad 64GB! 46 inch flatscreen LED HDTV for less than a hundred dollars! Why pay full price for a SONY Playstation ?
The basis of their appeal from the bidders' point of view is the old something for nothing - if all goes right and their bid is the winner, then they've managed to get valuable items for dirt cheap. But it's harder to figure out the attraction from the site owner's perspective. There is a potential for profits, sure, if many bidders subscribe to your auctions but the cost of acquiring those bidders is high and the auction must go on, regardless of the number of bidders, which raises the very real specter for owners that they may frequently be parting with merchandise for far less than its wholesale value.
The Penny Auction Business Model From the Bidder's Perspective
"Auction" is something of a misnomer when applied to the penny auction business model; it really functions more like a lottery combined with a game of "Chicken."  Bidders buy packets of 10 to 700 bids from the penny auction site's owner, at a price that varies between 60 cents to a dollar apiece, depending on the bulk discount and the owner's price point. Bidders use one of their packet bids each time they place an actual bid on an item.
At the auction's start, the item is priced at zero. Each bid raises the price of the item an incremental amount, generally between one and fifteen cents, that varies from site to site. Like EBay, an invisible stopwatch times the penny auction, and whenever a bid is placed on an item, the stopwatch advances by some measure of seconds. The bidder who manages to stay the course till the final countdown is complete wins the item.
Suppose yours is the winning bid on an iPad whose final price is $50. If you bid 500 times at $1 a bid - which, at a one penny hike in price per bid, will only raise the final price of the item by five dollars - the real price to you is the cost of the bids plus the item's final price which can frequently, as here, add up to more than the retail cost of the item.
Once bidders start bidding, an inexpert understanding of the laws of probability keeps them from stopping as though the 100 bids they've already made gives their 101st bid some kind of an edge. The same psychological mechanism drives slot machine players. Frequently, however, a bidder expends all his or her bids without winning the item.
The Penny Auction Business Model From the Site Owner's Perspective
Although some penny auction sites charge subscription fees, the main source of revenue for penny auction site owners is the sale of bids. At first glance, this may seem like a very efficient system for separating bidders from their money: after all, on an individual basis the bids do not cost very much so in the supercharged emotional state that attends an online auction, bidders can rationalize buying many of them.
But in order to offset the operational costs of the website - which includes buying the merchandise that's put up for auction - this effect must be multiplied by many users. And in order to make any profits, the effect must be multiplied by even more.
Again, suppose the winning price on an iPad is $50. This represents 5000 bids at a dollar apiece, or $5,000 less the price of the iPad (approximately $495) - a tidy profit. If, however, the winning price of the iPad is only $2.50, this represents 250 bids at a dollar apiece or $250 less the price of the iPad - which means the site owner is running at a loss.
For a penny auction site to succeed, it must attract a large bidder base But the cost of acquiring customers (bidders) - mostly through targeted, behavioral online advertising - can be very high. And those acquisition costs are a constant since most penny auction sites have a hard time retaining customers: bidders who fail to win items become disgruntled and walk away; and, too, there are always those rumors of auction bots artificially driving up final prices to contend with.
The Legalities of Penny Auction Sites
At present the operation of a penny auction website in the United States is legal. But will it remain that way? Many economists and game theorists who study the penny auction model have concluded that penny auctions are really a form of gambling. While Title VII of the Security and Accountability For Every Port Act, also known as the Unlawful Internet Gambling Enforcement Act, does not expressly prohibit Internet gambling, it does prohibit the transfer of funds from financial institutions to Internet gambling sites. If penny auctions were deemed to be a kind of gambling, these restrictions would also apply. Enjoined from accepting credit card payments, with PayPal as its only backup, penny auction sites would have a much harder time selling bids and we would begin seeing far fewer of them.

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