Auction Theory: Allocating scarce resources
By Dr. Santosh Kumar Mohapatra*
Auctions are important ingredients in business activities, modern markets, and in our everyday lives as well. For the year 2020, two American economists, Paul Milgrom ( 83-year-old )and Robert Wilson( 73 -year-old) were awarded the Nobel in economic science for improvements to auction theory and inventions of auction formats that drastically shifted how public resources are allocated.
Wilson was once Milgrom’s Ph.D. adviser and the two also happen to be neighbours. The award is technically known as the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. Since its establishment in 1969, it has been awarded 51 times and is now widely considered one of the Nobel prizes.
The Nobel Prize for economics is usually awarded to economists who have broken new ground in a particular sector of the discipline, or who have pioneered specific methods of investigation or analysis. Economists like to think of themselves as mathematicians’. But according to many international level economists, this year’s winners of the Nobel Prize in economics, however, seem to conceive of themselves more as engineers.
According to Nobel Committee, the auction theory of Paul Milgrom and Robert Wilson, “have benefitted sellers, buyers, and taxpayers around the world. The new auction formats are a beautiful example of how basic research can subsequently generate inventions that benefit society.
Both economists invented new formats for auctioning many interrelated objects on behalf of a seller motivated by doing well for society rather than simply achieving the highest price possible. They also designed auction formats for goods and services that are difficult to sell in a traditional way, such as radio frequencies. The unusual feature of this example is that the same people developed the theory and practical applications.
Before Wilson’s work in the 1960s and 1970s, research on auctions focused on each person’s private or subjective evaluation of the goods or services for sale. Robert Wilson developed the theory for auctions of objects with a common value — a value which is uncertain beforehand but, in the end, is the same for everyone.
Examples include the future value of radio frequencies or the volume of minerals in a particular area. Wilson showed why rational bidders tend to place bids below their own best estimate of the common value: they are worried about the winner’s curse — that is, about paying too much and losing out,
On the other hand, Paul Milgrom formulated a more general theory of auctions that not only allows common values but added to this framework by showing how both private values and common values influence the auction outcomes. They applied auction theory to more realistic settings and their basic research allowed them to invent entirely new auction formats
Milgrom complemented that with theories on “private values”, when the perceived value of something differs from bidder to bidder. He demonstrated that an auction format will give the seller higher expected revenue when bidders learn more about each other’s estimated values during the bidding process
They have explained how bidders seek to avoid the so-called “winner’s curse” of over-paying, and what happens when bidders gain a better understanding of their rivals’ sense of value. Milgrom and Wilson notably came up with formats for selling interrelated items simultaneously
The “winner’s curse” is a tendency for the winning bid in an auction to exceed the intrinsic value or true worth of an item. Originally, the term winner’s curse was coined as a result of companies bidding for offshore oil drilling rights in the Gulf of Mexico. In India, it’s been addressed by a floor price for bids. This method spawns another set of problems such as failed auctions because the floor price is too high.
The gap in auctioned vs. intrinsic value can typically be attributed to incomplete information, types of bidders, emotions, or a variety of other subjective factors that can influence bidders. In the investing world, the term often applies to initial public offerings but comprehensively a winner’s curse can happen in any market where auctions take place. The gap between intrinsic and auction value will generally be influenced by the bidders involved.
An auction is a common way to sell something. Auctions have evolved into highly sophisticated tools to sell a range of things. An auction is usually a process of buying and selling goods or services by offering them up for bid, taking bids, and then selling the item to the highest bidder or buying the item from the lowest bidder. The bidders compete against each other, with each subsequent bid being higher than the previous bid. Once an item is placed for sale, the auctioneer will start at a relatively low price to attract a large number of bidders.
The price increases each time someone makes a new, higher bid until finally, no other bidders are willing to offer more than the most recent bid, and the highest bidder takes the item. An auction is considered complete when the vendor accepts the highest bid offered and the buyer pays for the goods or services and takes possession of them.
The origin of auctions can be traced back to approximately 500 B.C. in ancient Greece when women were auctioned off for marriage. During this period, it was illegal for women to get married without going through the auction process. The auctioneer started the sale with the woman who was considered to be the most beautiful among all the women being auctioned that day.
The auction followed a descending pricing method, beginning with the highest price and going lower until the lowest bid was found, as long the bid price was more than, or equal to, the reserve price set by the seller. If the buyers could not get along with their new wives, they were allowed to recover their money.
However, modern auction theory — as opposed to auctions, which go back at least two-and-a-half millennia — rests on the work of John Nash, who generalized non-cooperative games beyond the special case of zero-sum games. In the past too, auction theory has won a Nobel. William Vickrey won the Nobel in 1996 for his work on auctions in which the values assigned by bidders were private. But, in real life, auctions are not just about how much one individual would enjoy staring at a particular piece of abstract art, as compared to another connoisseur.
In the United States, early auctions were used to sell farm produce, estates, and slaves. In the American Civil War, soldiers returning from war frequently sold their war plunder through auctions. However, the only soldiers who were allowed to sell the spoils of war were those holding a rank of colonel or higher.
The branch of economic theory dealing with auction types and participants’ behavior in auctions is called auction theory. Auction theory is a concept of transparent allocation of resources or items of business in a free market to the best bidder for optimum utilisation. It is a branch of applied economics. Auction theory prescribes different sets of rules or designs for transactions
Auctions help to sell a variety of products, including art, minerals, and online advertising. They can also take the shape of various characteristics: Objects can have a shared, common value for all bidders (such as commodities like oil) or private values that vary across bidders (like art). Bidders may know accurately what the object’s value is, or they may have imperfect information.
Bids can be open, meaning everyone can see them or closed. The success of an auction depends crucially on the aim of the auction, the rules which govern the process, the bidders’ idea of the value of the auctioned item, and the information asymmetry among bidders about the item.
The aim of the auction is very important. For example, if a charity aims to raise the highest possible amount of money by auctioning memorabilia of a sports celebrity, there’s hardly anything that can go wrong with the design. By contrast, if a government that wants to auction the telecom spectrum has more than one goal, challenges will be copious. One of those challenges, in the Indian experience, is to protect potential revenue by preventing collusion among bidders.
The business of auctioneering grew rapidly during the Great Depression when many people became bankrupt and, therefore, were forced to liquidate their assets. Auctions helped the individuals and businesses affected by the crisis to sell their assets quickly.
With the growth of technology in the 1990s, auctioneers started using computers, cell phones, and fax machines to increase the efficiency of their trade. Some auctioneers would take photographs of their items and project them onto big screens so that potential buyers could get a clear view of the items on sale.
In 1995, eBay, the first online bidding site, opened in the United States, setting a new stage for the auctioneering business. Online auctions are popular with sellers because of the huge number of potential bidders makes it easier for them to get a good price for virtually any item they have to sell. Buyers like having a wide range of products to choose from and being able to find just about anything they’re searching for to buy.
Although auctions are often considered synonymous with the sale of antiques, rare collectibles, and paintings, they are also used in investment banking. Investment bankers use auctions to attract the highest possible price when selling a company. The process starts by inviting multiple buyers to the auction.
T Paul R. Milgrom and Robert B. Wilson have not only improved how auctions work but also research that underlies much of today’s economy — from the way Google sells advertising to the way telecom companies acquire airwaves from the government.
Now in an open globalised market and technological advancements, items, and resources worth astronomical sums of money change hands every day in auctions. From houses, cars, and shops to electricity, telecom spectrum, minerals, and precious metals too are auctioned.
Governments use auctions to sell treasury bills, foreign exchange, oil fields, land, airports, railways, and similar resources as they move towards the privatization of the economy. Public procurements — including food grains for making them available to the vulnerable sections of society — are done through auctions.
Auctions thus impact every sphere of an individual’s life in a free-market society. If electricity generation or distribution is auctioned to a higher bidder, the power bills of every household and office will go up.
The link that Milgrom and Wilson built was the 1994 auction of telecommunications spectrum by the Federal Communications Commission, later called “the greatest auction in history.” In its 50th anniversary volume, the National Science Foundation used the $7 billion in revenue the auction generated as a justification for its years of support of game theorists.
Since then, auctions have become the gold standard for the distribution of all sorts of natural resources, from exploration permits to mining leases to railway franchises. It is almost taken for granted that, if properly designed, auctions will find the ideal balance between efficiency and revenue generation.
However, Bloomberg Quint columnist like Mihir Sharma argues that this Nobel-winning idea has failed India. In order to generate more revenues especially to bridge fiscal deficit, the government has taken recourse to assign spectrum to licensees instead of auction. It’s even worse when countries try to maximize just one variable, because for bureaucrats and politicians that variable is usually government revenue.
Economists generally don’t object because revenue is easier to measure than consumer utility, making their job simpler. The country’s telecom revolution — which drove its years of high growth in the 2000s — only took off after the government moved away from auctions and started assigning spectrum to licensees in return for a share of their revenue.
*The author is an Odisha-based eminent columnist/economist and social thinker. He can be reached through e-mail at [email protected]
DISCLAIMER: The views expressed in the article are solely those of the author and do not in any way represent the views of Sambad English.