Strategic collusion in auctions with externalities

We study a first‐price auction preceded by a negotiation stage with complete information, during which bidders may form a bidding ring. We prove that in the absence of externalities, the grand cartel forms in equilibrium, allowing ring members to gain the auctioned object for a minimal price. However, identity‐dependent externalities may lead to the formation of small rings, as often observed in practice. Potential ring members may condition their participation on high transfer payments as a compensation for their expected (negative) externalities if the ring forms. The cartel may therefore profitably exclude these bidders, although risking tougher competition in the auction. We also analyze ring (in)efficiency in the presence of externalities, showing that a ring may prefer sending an inefficient member to the auction, if the efficient member exerts threatening externalities on bidders outside the ring, which in turn leads to a higher winning price.