Bidding for the Best Outcome

THE HISTORY OF auctions goes as far back as 2,500 years and those were straightforward in character. Even when in 193CE a rebellious wing of the Roman army did a coup and auctioned off the entire empire, they didn’t bother with the fine print. Make your bid and the highest one got to take it all. Even in the modern world, most auctions are likewise. But what if a government wants to sell off rights to its natural resources, like minerals or spectrum? For an individual, owning a natural resource would not lead to a dilemma about how much to profit from it. If you find an oil well in your backyard, it is quite clear what you will and should do—sell it for the maximum you can get. When it comes to governments, it can get complicated because its remit is not maximisation of revenues but the public good. Take India’s telecom spectrum story. It began with spectrum auctions but then the Government gave it away at throwaway prices in 2008 on a first-come-first-served basis. It lost a lot of revenue but possibly fuelled a telecom revolution, making phone calls so cheap that even the poorest could afford mobile connections. It also led to fantastic corruption that then took the policy in the opposite direction of auctions again because one of the things that auctions ensure is transparency. What Paul Milgrom and Robert Wilson, who won the Economics Nobel this year, showed was that intelligent auction design could maximise benefits for both sellers and buyers and also, importantly, with public resources, ensure that their utility is maximised with the right bidders getting them.

The Nobel committee’s press release on the two explained their individual contributions to auction theory. Wilson, it said, ‘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.’ Milgrom was responsible for a theory that in addition to common values also factored in private values, where each bidder has a different value for the same item. ‘He analysed the bidding strategies in a number of well-known auction formats, demonstrating that a format will give the seller higher expected revenue when bidders learn more about each other’s estimated values during bidding,’ said the release.

At a news conference hosted by Stanford University where both of them teach, in answer to a question on how their methods differ from traditional auctions, Wilson answered that the normal understanding of auctions is the one where items come up for bids one after the other. That, he said, was how in his childhood he saw auctions of horses or cattle happen, with cows paraded in and sold one by one by an auctioneer with a gavel. Their work however was to do with auctions where more complexity was involved; the items being sold were often connected and complemented each other. An example he gave was of spectrum auctions. If someone is trying to get two spectrum licences that cover Northern and Southern California, bids too high and wins the first, when the other half of the state comes up, he has no money and ends up wishing he hadn’t bought the first.

And without both, he has a problem because he can’t cover the entire state. “Northern and Southern California licences are complements in providing coverage in the state. And so our auction was designed to enable the assembly of efficient packages. This is not the kind of problem you run into in the parade of cattle,” he said.

A Stanford News article on the duo explained how their research revolutionised the allocations of spectrum in the US in the early 1990s and then across the world. At the time, the US Federal Communications Commission (FCC) used to sell radio frequencies through applications and lotteries. ‘As mobile phone use expanded, the processes became unreasonably costly to the government and unsatisfactory to the mobile service providers. To address this issue, Milgrom and Wilson invented a new auction format, called Simultaneous Multiple Round Auction (SMRA). In these auctions, all biddable items are offered simultaneously and bidders can bid on any portion of the items. The bids start low, in order to avoid the winner’s curse, and the auction ends when no bids are placed in a round. The first SMRA auction in 1994 sold 10 licenses over 47 rounds, fetching $617 million. Many governments around the world adopted SMRA auctions for their own purposes and further refinements have resulted in additional new auction formats,’ it said.

The great strength of American universities is how theory seamlessly overlaps with the world of business. Students and professors can use their knowledge for profit. Milgrom helped Time Warner and Comcast in a spectrum auction in 2006 and saved them more than a billion dollars. Writing about this aspect, The Economist said: ‘Mr Milgrom and Mr Wilson became the embodiment of the economist as engineer: applying theory in order to devise functional solutions to such problems. As a result the researchers are more enmeshed in real-world problems than the typical prizewinner.’

In 2009, Milgrom founded a company called Auctionomics which designs auctions and also actively participates in them on behalf of clients. These could be governments wanting to auction a resource or companies that need help in bidding or selling. And in 2010 Milgrom spoke of how he helped a client in the 3G spectrum sale auction in India by exploiting a design flaw. In a post on his website in May that year, he wrote: ‘Two big spectrum auctions in India and Germany ended this week. The 3G auction in India yielded nearly US$15 billion for the Indian treasury for about 40MHz of bandwidth covering the whole nation. This includes the 10MHz that had previously been allocated to the two state-owned telecoms, which now have to pay the prices set in the auction. While revenues in the Indian auction were much higher than the government had forecast, they fell far short of their potential. The bidder that I advised was able to take advantage of the auction’s unique and flawed closing rule to end the auction before the still-remaining competitors had exhausted their demonstrated budgets.’

He also had tips for better auction design in the same piece. As India keeps engaging with the issue of sale of its vast natural resources as a way of gathering revenue, especially with the recession, intelligent auction design will play a big role in ensuring transparency and efficiency. The theories of the two economists will have much to do with it.

auctionseconomicsNobel PrizePaul MilgromRobert Wilson