The Sveriges Riksbank Prize, or the Economics Nobel, to Paul Milgrom and Robert Wilson has brought Auction Theory and its practical relevance in Economics. The Stanford University economists contributed to auction theory literature and invented new auction formats. The mechanism of auction can be effectively used for a variety of items and applied for market-oriented outcomes. This year’s Nobel got a great deal of attention and will have larger implications for economic theory as the findings of Milgrom and Wilson has reduced the gap between auction theory and practice.
Economists have been grappling with the problem of theory-policy gap, with theoretical advancement brought about by academicians were not to effective use by policy makers. Apart from making a breakthrough in the particular subject field, the Stanford economists have made notable progress in academia-industry–policy linkages. This will lead to a re-orientation of public policy formulations with suitable academic inputs.
How important is auction theory for practitioners? What is its current relevance and how academia plays a role in successful policymaking?
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Decoding the Auction theory
An auction is essentially a mechanism for buying and selling goods and services. Economics of auction helps the discovery of pricing. The theoretical part deals with the design of an auction, its rules, the strategic behaviour of bidders and finally the outcome. According to Wilson’s work, any auction has a common value that is uncertain before and after the process. A rational bidder places his/her bid at below the common value to gain out of the auction. However, there exists a situation of Winner’s Curse, wherein the lack of knowledge about the object may lead to paying more than the common value. Milgrom says that in general theory of auction there are private values which vary from bidder to bidder apart from the common value.
The Nobel laurates analysed the bidding strategies and behaviour of bidders in a numerable format for various commodities and situations. The seller receives maximum returns when bidders are mutually aware about the estimated values. The format or rules, details about the object and any additional information bidders gather are the key determinants of the outcome of an auction.
“Auction design is an engineering activity. It entails practical judgements, guided by theory and all available evidence, but it uses ad hoc methods to resolve issues about which theory is silent, Milgrom says.”
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Applications of Auction Theory
In 1994, Federal Communications Commission (FCC), the communication watchdog in the United States, adopted ‘Simultaneous Ascending Auctions (SAA)’ suggested by Milgrom and Wilson for selling licence to use radio spectrum. An SAA auction has multiple rounds and in each round the seller sets minimum acceptable bid for each object. Each bidder is allowed to submit bids on any number of items subject to activity rules designed by Wilson and Milgrom. If there are multiple bids on a licence, the seller selects randomly to become the standing high bid.
This mode of auction essentially reduced the administrative role of allocating the spectrum resources and allowed market forces to decide the pricing. Through the bidding, the authorities gained enormous value for spectrums allocated and earned handsome revenues. This method has been replicated in many world nations. The analysis based on tatonnement (French word for trial and error) theory, which considers auction as the best effective mechanism for price discovery and efficient allocation of resource. This was the first time when academic inputs were adopted fully to maintain efficiency and transparency in an auction process.
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Auction theory in practice
Electricity, treasury bills, spectrum, energy and internet are some well-known markets that attempt auctions for price discovery and efficient allocation. The United Kingdom was the first electricity market in the world opted for an auction procedure and went for deregulation. But it was not as successful as perceived because of the discriminatory auction design that is less transparent. However, the US experiments proved to be successful and many countries adopted the method.
Treasury bills auction is another area where auction happens in a divisible homogeneous good. The current auction theory is more relevant to treasury markets, wherein a participant with predictable and stable requirements can have more than one bid. This may pave way for collusion in repeated games.
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Spectrum auction are complicated procedures where multiple heterogenous objects are auctioned. Under this, complementarities of objects make it more complex and therefore the SAA design was opted. This kind of auctions exogenously fix number of bidders who have positive known value for each of the heterogenous objects and are restricted to buy at most a single license. This case rules out the possibility of collusion and the unique Nash equilibrium — an outcome which is worse for all players than mutual co-operation– is efficient.
Among all these, internet auction market is the most important one wherein online consumer auctions are run by e-commerce sites. The business-to-business auto part auctions conceived by some big auto players are notable here.
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Of course, there are certain caveats in auction such as information about other strategic bidders and value of the objects are highly crucial. Otherwise, it may have situations like winner’s curse. In high frequency trading like finance, it is riskier to take such an approach and traders generally opt for theoretical and applied techniques for price discovery.
Many world nations successfully devised auction procedures for price discovery and efficient allocation of resources through a professional and transparent approach. This involves appropriate utilisation of academic inputs in policy making. The role of academia is reinstated and well acknowledged through the Nobel announcement. Economics and its approaches are now employed in subjects such as physics and chemistry where scientists find solutions to real-life problems. This year’s Nobel is an eye-opener that will reshape our education system and policy making process to overcome the theory-practice gap.
Dr Aswathy Rachel Varughese is Assistant Professor, Department of Applied Economics, Cochin University of Science and Technology.