Combining buy-in penalties with commissions at auction houses

Most auction sellers consign property to auction houses rather than holding the auction themselves. In addition to charging sellers a commission on property that sells in the auction, many auction houses also specify buy-in penalties in auction contracts. This is an amount the seller must pay the auction house if the property fails to sell at auction. An important managerial question for auction houses is whether and when buy-in penalties can increase revenues of the auction house, seller, or both, and what combinations of commission and buy-in penalty to use. We show that auctions which combine buy-in penalties with lower commissions Pareto-dominate auctions that use only commissions. This strategy motivates the seller to set a lower reserve, which creates a surplus in auction revenues that can go to one or both parties. This strategy is Pareto-dominant even if the auction house and the seller are uncertain about the number of bidders at the auction, or the auction house is uncertain about the seller's own valuation for the property, at the time the buy-in penalty, commission, and reserve are contractually set. We also discuss the incentive issues raised by this strategy.