It was the middle of the night when the phone rang. He answered the phone, and then walked across the street and knocked on his neighbour’s door to congratulate him. Meet Robert Wilson and Paul Milgrom – winners of the 2020 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, aka the Nobel Prize in Economics. Paul Milgrom is the Shirley R and Leonard W Ely Jr Professor of Humanities and Sciences at Stanford University. He is also a professor of Management Science and Engineering and has been at Stanford since 1987. Robert Wilson is the Adams Distinguished Professor of Management, Emeritus at Stanford and has been there since 1964. He is the one who walked across the street to wake up his neighbour and tell him that they had just won the Nobel Prize – for improvements to auction theory and inventions of new auction formats. Robert Wilson happens to be Paul Milgrom’s PhD supervisor. Incidentally two of Wilson’s other advisee’s Al Roth and Bengt Holmstrom have also received the Nobel Prize in 2012 and 2016 respectively.
Introducing auctions
All of us have a connection to auctions in some way or the other. Our mobile phone coverage, the sale of government bonds that forms a part of our portfolio – are all determined through auctions. Some of us may even have taken part in one to purchase something of a platform like eBay.
Different types of auctions are used in different contexts with the English and Dutch auctions being some of the oldest formats. An English auction begins with a low initial price and bidding goes on till there is only one participant left. In a Dutch auction, the opposite happens wherein the auctioneer starts with a high price and keeps lowering it until someone buys the item. The Dutch auction goes much faster – the Dutch needed a format to auction all those beautiful tulips that grow in the Netherlands. These auctions take place in the open – where participants can see what the other bidders are doing and are called open bid auctions. In contrast, all those government tender ads that you see in the newspapers are what we call sealed bid auctions where every participant submits a closed bid for the tender.
Auctions are also classified in other ways. In a first-price auction, the winner pays the highest price, that is, his own bidding amount. The highest bidder in a second-price auctions is the winner, but pays the amount bid by the second highest bidder. The game-theoretic analysis of English auction is similar to that of second price auctions, and Dutch auctions are strategically equivalent to first price auctions. An excellent introduction to these and other advanced topics on auctions can be found in Professor Vijay Krishna’s book titled Auction Theory.
An important fact about auctions is that winning may not always be a good outcome. Many times a bidder may get caught in a bidding war (or may not be well-informed) and even bid and pay more for an item than it’s worth or intrinsic value – a phenomenon known as the winner’s curse. A moment’s reflection will immediately tell us that the winner’s curse will be worse in first-price auctions and an auctioneer like the Government selling spectrum may not want that.
Common and private values
Typically, the value of an object the people are bidding on in an auction can be assumed to have two different components: a common value and a private value. For instance, a house in a specific neighbourhood has a common value - its expected price in the future – which is the same for everyone. Different individuals, however, might value it very differently depending for instance on the distance to their work and the gap between the actual features of the house – which are same for everyone – and desired features of the house that will depend on an individual’s needs and tastes. This defines the private value component of the object. Two art collectors might value good art, but a MF Hussain lover might value an Arpana Caur piece differently from someone who likes Caur’s art more. Interestingly, the 1996 Nobel Prize was given to William Vickrey for analysing (among other things) auctions in which the bidders only have private values. For instance, an answer to a question like how much would you be willing to pay for a dinner with this year’s Nobel laureates? Or last year’s Nobel Prize winner Esther Duflo and Abhjit Bannerjee.
Professor Robert Wilson created a framework to analyse auctions involving common values and the behaviours of bidders in first-price auctions. His work shows that when the true value of the auction object is not known with certainty (no consensus about the value), then its final price will be lower and when the bidders are all not equally informed, i.e., we have information asymmetry among the bidders, it makes the problem of winner’s curse even worse. He then developed the optimal bidding strategy for such conditions.
Professor Paul Milgrom takes auction theory further by developing the framework to analyse auctions with both common and private values. His work sheds light on the winner’s curse in different kinds of auctions. For instance, the winner’s curse is a bigger problem in Dutch auction than English auction, because no new information is generated during the Dutch auction. Participants in an English auction learn about the valuation of others during the auction process since bidders drop out as the price keeps increasing.
New auction formats
Besides their contributions to the theory of auctions, Milgrom and Wilson have also been responsible for the design of new types of auctions that can be used in complex situations. Their auction method has been most notably used in the telecom sector where the license for frequency bands in different regions are complementary but used to be sold in separate auctions. Since there is a great uncertainty about subsequent auction outcomes, the bid price of potential mobile phone operators would be skewed downwards and would attract speculators that try to sell it for a higher price in the secondary market.
A new auction format known as the Simultaneous Multiple Round Auction (SMRA) first suggested by Milgrom and Wilson was successfully used by the US authorities in the spectrum auction in 1994. Following its huge success, SMRA subsequently adopted by several countries in the world including India and used in the auctioning of other services, e.g., natural gas and electricity. In the SMRA format, all radio frequencies are offered simultaneously, and multiple bids are allowed. All of this mitigates uncertainty as well as the winner’s curse. It is really the theory and innovativeness of this design that makes the work of this duo absolutely amazing.
Why it matters?
Some people have questioned the usefulness of giving the Nobel Prize to those working in the area of auctions. Let us know quickly answer why this matters. First, SMRA leads to an efficient allocation of a public resource like spectrum because those who value the spectrum more are likely to obtain the license. Second, it is a win-win because winner’s curse is lower and since bids are not skewed downward, the government earns larger revenues. And finally, it is these sorts of auctions that have laid the foundations of the modern telecommunications driven economy. It is indeed hard to imagine a more deserving pair!
(Chandan K Jha teaches economics and finance at LeMoyne College. Sudipta Sarangi teaches economics at Virginia Tech and is the author of forthcoming book The Economics of Small Things.)
