Updated: October 14, 2020 9:32:11 am
Robert Wilson, left, and Paul Milgrom wear masks while posing for a photo in Stanford, California (Andrew Brodhead / Stanford News Service via AP)
On Monday, the Royal Swedish Academy of Sciences awarded this year’s Sveriges Riksbank Prize in Economic Sciences in memory of Alfred Nobel, popularly known, albeit incorrectly, as the Nobel Prize in Economics. to Paul R Milgrom and Robert B Wilson. Both winners are currently at Stanford University, where they teach in different departments.
In its announcement, the Academy said the pair were receiving the award for “improvements in auction theory and inventions of new auction formats.” They will equally share the prize money of 10 million SEK, approximately Rs 8.33 crore.
What is auction theory?
Basically, it’s about how auctions lead to the discovery of the price of a commodity. Auction theory studies how auctions are designed, what rules govern them, how bidders behave, and what results are obtained.
When you think of auctions, you typically imagine auctioning off the property of a bankrupt person to pay off creditors. In fact, this is the oldest form of auction. This simple design of such an auction, the highest open bidder to win the property (or product in question), is also intuitively attractive.
But over time, and especially over the past three decades, more and more goods and services have been auctioned. The nature of these commodities is very different. For example, the property of a bankrupt person is completely different from the spectrum for radio or telecommunications use. Similarly, carbon dioxide credits are quite different from the spot market for buying electricity, which, in turn, is quite different from choosing which company should get the right to collect local garbage.
In other words, no auction layout fits all types of products or sellers.
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This is also true because the purpose of an auction also differs with the commodity and the entity conducting the auction. Most of the time, private sellers want to maximize their profits, while public authorities may have other goals in mind.
The Auction Winner’s Curse
For example, when selling telecommunications spectrum, a government might think about maximizing its revenue or aiming to make telecommunications more affordable for everyone. If you want to maximize revenue, the auction has to be designed in one way, but doing so will mean that the company that ultimately wins the contract will make telecom services more expensive and, in the process, deprive the poorest sectors of telephony and affordable internet access. The advantage, however, is that the government will get more money in your kitty and can use it in any way it wants, possibly even subsidizing the telecommunications costs of the poorest.
On the other hand, if the government’s goal is to allow the wider society to access the benefits of the telecommunications revolution and to allow even the poorest to use the internet at an affordable price, you may want to focus more on the best way to guarantee that a company that. In fact, before auctions became the norm for limited resources like radio waves, governments used to allocate them like a beauty pageant would be held. This would involve asking how a company could use the spectrum and assessing which company is best suited to receive the license. This approach, however, led to a proliferation of pressure groups.
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But even when the focus of a beauty pageant was replaced by an auction, it mattered how the auction was designed. For example, if spectrum is auctioned regionally, national players may not get continuous access to optimal spectrum quality across the country; As a result, they may not bid as aggressively. In the US, that mistake led to a second-hand market where companies were trading with each other with little revenue to the government.
The way an auction is designed, therefore, has a tremendous impact not only on buyers and sellers, but on society in general.
What are the key variables that determine the outcome of an auction?
You need to understand three key variables when designing an auction.
One is the auction rules. Imagine participating in an auction. Your bidding behavior is likely to differ if the rules stipulate open bids as opposed to closed / sealed bids. The same applies to single offers versus multiple offers, or if the offers are made one after the other or if everyone makes offers at the same time.
The second variable is the merchandise or service that is put up for auction. In essence, the question is how each bidder values an item. This is not always easy to determine. In terms of telecommunications spectrum, it might be easier to set the correct value for each bidder because most bidders are likely to use the same spectrum. This is called the “common” value of an object. But this may not be the case with some other commodities, for example a paint. Person A can obtain considerably more “private” or personal value, just by looking endlessly, than Person B. In most auctions, bidders assign both “common” and “private” values to the object being auctioned and This affects your eventual bids.
The third variable is uncertainty. For example, which bidder has what information about the item, or even the value that another bidder associates with the item.
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Milgrom and Wilson have done pioneering work in auction theory and much of our current knowledge is due to their research.
As the Academy notes, “Wilson developed the theory of auctions of objects with a common value, a value that is uncertain in advance but, in the end, is the same for everyone.” Wilson showed what the “winner’s curse” is at auction and how it affects bidding. As shown in the illustration, it is possible to outbid – $ 50 when the actual value is closer to $ 25. By doing so, you win the auction but actually lose. The winner’s curse explains “why rational bidders tend to place bids below their best estimate of common value: they are concerned about the winner’s curse, that is, overpaying and losing.”
Milgrom “formulated a more general theory of auctions that not only allows common values but also private values that vary from one bidder to another.” He “analyzed the bidding strategies in a number of known auction formats, showing that one format will give the seller higher expected revenue when bidders learn more about the estimated values of others during the bidding.”
With each passing year, as societies became more complex, Milgrom and Wilson responded by inventing new formats “to auction many interrelated objects simultaneously, on behalf of a seller motivated by broad social benefit rather than maximum revenue.” .
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