Optimal Reverse‐Pricing Mechanisms

Reverse pricing is a market mechanism under which a consumer's bid for a product leads to a sale if the bid exceeds a hidden acceptance threshold the seller has set in advance. The seller faces two key decisions in designing such a mechanism. First, he must decide where in the process to collect the revenue–that is, whether to commit to a minimum markup above cost (and thus define the bid‐acceptance threshold given cost) and whether to set a fee for the consumer's right to bid. Second, the seller must decide whether to facilitate or hinder consumer learning about the current bid‐acceptance threshold. We analyze these decisions for a profit‐maximizing small intermediary retailer selling to consumers who can also purchase the product in an outside posted‐price market. The optimal revenue model is to charge a fee for the right to bid and then accept all bids above cost, rather than to set a positive minimum markup above cost. Avoiding minimum markups in favor of a bidding fee is more profitable because of increased efficiency arising from more entry by consumers and higher bids by the entrants. When consumers learn about the bid‐acceptance threshold before they enter the market, efficiency increases further, and generating revenue through a bidding fee can compensate the seller for his loss of information rent when the competition from the outside posted‐price firm is relatively weak.