Economic Sciences Nobel : Auctions, they’re all around us

Robert Wilson’s and Paul Milgrom’s auction strategy was used for allocating radio spectrums to telecom operators in the US in in 1994. Since then, this strategy has been used across countries and across sectors such as electricity and natural gas
Paul Milgrom Robert Wilson
Paul Milgrom Robert Wilson

Amidst the COVID-19 gloom, the Nobel Committee continued to give Nobel Prizes. The Economics Nobel was awarded to Paul Milgrom and Robert Wilson (both professors at Stanford University) “for improvements to auction theory and inventions of new auction formats”. The prize has led to criticism on social media that the committee could have been more sensitive and given awards to those working in pressing problems of today such as healthcare and unemployment. There are others who have criticised the old problem of selecting awardees from developed world/US. In fact, this year all the prizes have gone to researchers based in US universities.

The duo join William Vickrey who was awarded the prize for auction theory in 1996. However, Vickrey died soon after the announcement and was awarded the prize posthumously. Milgrom gave the Prize lecture on behalf of Vickrey summarising latter’s contributions to auction theory. The committee announced that the 2020 prizes will be awarded over a digital ceremony due to the ongoing pandemic. On this front, Milgrom is lucky as he has already witnessed the ceremony.

The citation points that “auctions have long history” starting from ancient Romans who auctioned properties of those unable to pay taxes. In fact, most of us living in India are often introduced to auctions using similar narratives, via the movies. The movie plot is often around a villain who is behind auctioning of the actor’s properties, only for the actor to grow up and take revenge. In recent years, the Indian Premier League (IPL) has also exposed us to auctions where teams bid for cricket players.

Before understanding the contributions of Milgrom and Wilson, we need to figure auction theory.

The citation says auctions have three features. First, is rules of auction which deals with type of bidding (open/closed), number of times one can bid, pricing (first price/second price) and so on. Second is the valuation of auctioned object which discusses whether each bidder has same or differentiated values. Third is the uncertainty which deals with how much information participants have about the object. Auction theory helps us understand all these three factors and how certain auction designs will lead to what kind of outcomes.

Historically, there have been two kinds of auction houses. There is the English auction where one starts with a low price, prices rise with each bid and the object is awarded to the highest bidder (movies/IPL feature this type). The other kind is Dutch auction where one starts with a higher price, prices decline with each bid and object is awarded to whoever agrees to buy at the announced price.

Vickrey showed that the English and Dutch auctions give the same revenue to the seller provided the usual economics assumption of rationality and risk neutrality. Milgrom on the other hand showed that in English auctions the bidders have more information as they observe the dropped bidders value and thus bid around their estimated values. Dutch auctions provides no new information and thus winners curse is more severe in the case of Dutch auctions.

In auctions, there is this distinction between common value and private values. For most auctioned objects, bidders have common values which is same across bidders. However, there will be private value as well based on how much the person values the object over others. Take the case of a mutual fund bidding for a government security. The common value here is future interest rate whereas private value is the risk profile of investors. Vickrey’s and Wilson’s works mainly focuses on auctions under common values, while Milgrom shows auctions under both common and private values.

Vickrey also came up with the idea of second best price for auctions. Usually, we see that bidders try and outdo each other (we see this in movies) by bidding higher prices. Such cases lead to ‘winner’s curse’, where the winner is actually the loser as they have bid at a price much higher than their value. Thus, Vickrey suggested that such winners should actually pay the second highest price. Building over Vickrey’s work, Wilson showed how the bidders will try and bid lower to avoid the curse leading to lower revenues for the seller. In case there is information asymmetry between bidders, the bidding could be even lower and the auction could collapse.

Wilson and Milgrom also applied the theory to practice by designing auctions for allocating radio spectrums to telecom operators in the United States in 1994. Earlier, the US government used to allot these resources for free. The big question was how to allocate spectrum efficiently so that all three stakeholders — radio companies, government and customers — benefit? The duo designed a new auction format named ‘Simultaneous Multiple Round Auction’ (SMRA). The idea was to auction the spectrum across different geographical areas simultaneously so that operators can figure the synergies. The SMRA started with low prices and allowed repeated bids to avoid the winner’s curse. The government sold 10 licences in 47 bidding rounds for a total of $617 million.

Overtime, the US government has earned $120 billion using auctions in the period 1994-2014. This spectrum auction strategy has been used across countries and across sectors such as electricity and natural gas. If the Indian governments had read up works of Milgrom and Wilson, they could have avoided the “winter of discontent”, a phrase used by Montek Ahluwalia in his recent book to explain the 2G and coal scams.

To sum up, choosing the auction theory for the 2020 prize is exciting as we see auctions all around us without realising. The citation mentions that world’s oldest auction house, Stockholms Auktionsverk, founded in 1674 in Sweden. It is interesting to note that the same country houses the world’s oldest central bank as well which gives the Nobel Prize for economics.

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