The story so far: American economists Paul R. Milgrom and Robert B. Wilson, both of whom teach at Stanford University, were awarded the 2020 economics Nobel Prize last week. This year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was awarded to the duo “for improvements to auction theory and inventions of new auction formats”. The Nobel Prize committee noted that Dr. Milgrom and Dr. Wilson did not just come up with original ideas in auction theory, but they also played a crucial role in implementing their ideas.
What is auction theory?
Auction theory is a branch of economics that deals with, as the name suggests, auctions. Auctions are important to economists because they are the most widely used and also the most efficient mechanism to allocate scarce resources. The allocation of scarce resources, in turn, matters to economists because there is a limited supply of resources on earth when compared to unlimited human needs, and hence they need to be allocated only to the most urgent needs of society. In particular, auction theory deals with the various ways in which auctions can be designed to improve seller revenues, increase benefits to consumers, or even achieve both these goals at the same time.
How is it relevant?
Throughout history, countries have tried to allocate resources in various ways. Some have tried to do it through political markets, but this has often led to biased outcomes. Think of how the rationing of essential goods worked in various State-controlled economies. People who were close to the bureaucracy and the political class came out ahead of others. Lotteries are another way to allocate resources, but they do not ensure that scarce resources are allocated to people who value it the most.
Auctions, for a good reason, have been the most common tool for thousands of years used by societies to allocate scarce resources. When potential buyers compete to purchase goods in an auction, it helps sellers discover those buyers who value the goods the most. Further, selling goods to the highest bidder also helps the seller maximise his or her revenues. So, both buyers and sellers benefit from auctions.
What are its applications?
Auctions happen almost everywhere in the modern world. Even the sale of groceries in retail stores is based on an auction, albeit an implicit one that is relatively slow to adjust to changing market conditions. For instance, a supermarket manager, just as an auctioneer, tries to price his goods based on how much of it is sold during a certain day, week, or month. If there is a huge demand for a certain product and shelves empty quickly, the supermarket manager will raise its price to prevent a shortage. If another product fails to sell as fast as expected, its price may be lowered in order to clear any unsold inventory.
More sophisticated and explicit auction mechanisms are used in the allocation of capital goods such as spectrum and minerals. But whether it is the auction of spectrum waves or the sale of fruits and vegetables, auctions are at the core of allocation of scarce resources in a market economy.
What are the economists’ contributions?
To understand Dr. Milgrom and Dr. Wilson’s contributions, it is important to take note of the criticisms levelled against auctions. The most common one is that auctions can lead buyers to overpay for resources whose value is uncertain to them. This criticism, popularly known as the ‘winner’s curse’ , is based on a study that showed how buyers who overpaid for U.S. oil leases in the 1970s earned low returns. Dr. Wilson was the first to study this matter. He found that rational bidders may decide to underpay for resources in order to avoid the ‘winner’s curse’, and argued that sellers can get better bids for their goods if they share more information about it with potential buyers. Dr. Milgrom added further nuance to this analysis by arguing that individual bidders may still submit vastly different bids due to their unique circumstances. A company that can sell oil at a higher price or process it at a lower cost, for instance, may be willing to pay more for crude oil.
Secondly, economists traditionally working on auction theory believed that all auctions are the same when it comes to the revenues that they managed to bring in for sellers. The auction format, in other words, did not matter. This is known as the ‘revenue equivalence theorem’. But Dr. Milgrom showed that the auction format can actually have a huge impact on the revenues earned by sellers.
The most famous case of an auction gone wrong for the seller was the spectrum auction in New Zealand in 1990. In what is called a ‘Vickrey auction’ , where the winner of the auction is mandated to pay only the second-best bid, a company that bid NZ$1,00,000 eventually paid just NZ$6 and another that bid NZ$70,00,000 only paid NZ$5,000.
In particular, Dr. Milgrom showed how Dutch auctions, in which the auctioneer lowers the price of the product until a buyer bids for it, can help sellers earn more revenues than English auctions. In the case of English auctions, the price rises based on higher bids submitted by competing buyers. But as soon as some of the bidders drop out of the auction as the price rises, the remaining bidders become more cautious about bidding higher prices.
Dr. Milgrom and Dr. Wilson, however, are most popular for their contribution towards devising new, real-world auction formats. The combinatorial auctions designed by the duo, for instance, have been used to sell complex goods such as spectrum as bundles, instead of as individual units. Earlier, governments sold spectrum rights on a piecemeal basis, which made it unappealing to companies which demanded spectra in a bundle. This led to private speculators earning billions in the secondary market by reselling spectrum, while the government was starved of revenues that it could have easily earned with better auction design.
How do these contributions matter?
The contributions of Dr. Milgrom and Dr. Wilson have helped governments and private companies design their auctions better. This has, in turn, helped in the better allocation of scarce resources and offered more incentives for sellers to produce complex goods.
In fact, Auctionomics, a firm Dr. Milgrom co-founded, has been helping companies and governments design auctions, thus adding to other innovative auction formats adopted over the centuries by sellers trying to maximise revenues. Lastly, not all economists necessarily agree with the popular use of Dr. Milgrom and Dr. Wilson’s work on the ‘winner’s curse’ to take a dim view of auctions. They argue that while enthusiastic bidding may lower the returns earned by companies, it will not necessarily lead to higher prices for consumers, as is commonly believed. This is because in any competitive market, pricing of consumer goods is based on what the market will bear, rather than on sunk costs. Further, persistent overbidding is unlikely as financial losses weed out inefficient speculators over time.
