Auction Theory and Inventions of New Auction Formats

Auction Theory and Inventions of New Auction Formats
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People have always sold things to the highest bidder or bought them from whoever makes the cheapest offer. Nowadays, objects worth astronomical sums of money change hands every day in auctions, not only household objects, art and antiquities, but also securities, minerals and energy. Public procurements can also be conducted as auctions.

Using auction theory, researchers try to understand the outcomes of different rules for bidding and final prices, the auction format. The analysis is difficult, because bidders behave strategically, based on the available information. They take into consideration both what they know themselves and what they believe other bidders to know.

This year, the Nobel Prize for Economics was awarded to Paul R Milgrom and Robert B Wilson for “improvements to auction theory and inventions of new auction formats”.

Robert Wilson 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.

Paul Milgrom formulated a more general theory of auctions that not only allows common values but also private values that vary from bidder to bidder. He analysed the bidding strategies in several 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.

Over time, societies have allocated ever more complex objects among users, such as landing slots and radio frequencies. In response, Milgrom and Wilson invented new formats for auctioning off many interrelated objects simultaneously, on behalf of a seller motivated by broad societal benefit rather than maximal revenue. In 1994, the US authorities first used one of their auction formats to sell radio frequencies to telecom operators. Since then, many other countries have followed suit.

“This year’s Laureates in Economic Sciences started out with a fundamental theory and later used their results in practical applications, which have spread globally. Their discoveries are of great benefit to society,” says Peter Fredriksson, chair of the Prize Committee.

Auction theory studies how auctions are designed, what rules govern them, how bidders behave and what outcomes are achieved.

When one thinks of auctions, one typically imagines the auction of a bankrupt person’s property to pay off his creditors.

Indeed, this is the oldest form of auction. This simple design of such an auction - the highest open bidder getting the property (or the commodity in question) is intuitively appealing as well.

Evolving Definitions of Auction

Over time, and especially over the last three decades, more and more goods and services have been brought under auction. The nature of these commodities differs sharply. For instance, a bankrupt person’s property is starkly different from the spectrum for radio or telecom use.

Similarly, carbon dioxide emission 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 the local garbage.

In other words, no one auction design fits all types of commodities or seller.

There are three key variables that need to be understood:

  1. Rules of the Auction

Imagine participating in an auction. Your bidding behaviour is likely to differ if the rules stipulate open bids as against closed/sealed bids.

The same applies to single bids versus multiple bids, or whether bids are made one after another or everyone bids at the same time.

  1. Commodity or Service

The second variable is the commodity or service being put up for auction. In essence, the question is how each bidder values an item.

This is not always easy to ascertain. In terms of telecom spectrum, it might be easier to peg the right value for each bidder because most bidders are likely to put the spectrum to the same use.

This is called the “common” value of an object.

  1. Uncertainty

The third variable is uncertainty. For instance, which bidder has what information about the object, or even the value another bidder associates with the object.

Auctions are seen as a potentially efficient mechanism for the sale and purchase of goods. They are used for a variety of goods, but, in particular for rare expensive goods, which are hard to price. Auctions have also been made much easier with the advent of the internet which makes possible online bidding.

Ascending Price Auction

This is the simplest and most common type of auction. The highest bidder wins the right to buy the good. Sometimes the seller may set a reserve price to prevent the good for being sold for less than they are happy with.

Descending Price Auction ‘Dutch Auction’

In this type of auction, the price starts high and then starts to fall. The first person to bid gets to buy the good. This type of auction is a way to extract consumer surplus and practise first-degree price discrimination because in theory, the buyer will pay the maximum price, he is happy with. If they don’t, they could lose out. However, if he knows the price other people are willing to pay, he may be able to risk bidding at a lower price. But this becomes risky and if his information is wrong, he could lose out.

Significance of Auction Theory

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. For Ex: The rationing of essential goods worked in 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.

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 criticisms levelled against auctions and what are the economist’s contribution?

Issue of Winner’s Curse

The winner's curse is a tendency for the winning bid in an auction to exceed the intrinsic value or true worth of an item. The gap in auctioned vs. intrinsic value can typically be attributed to incomplete information, bidders, emotions, or a variety of other subjective factors that can influence bidders. In general, subjective factors usually create a value gap because the bidder faces a difficult time determining and rationalizing an item's true intrinsic value. As a result, the largest overestimation of an item's value ends up winning the auction.

The winner's curse can lead to an example of buyer's remorse, wherein the buyer of something feels like they've overpaid in retrospect.

Originally, the term winner's curse was coined as a result of companies bidding for offshore oil drilling rights in the Gulf of Mexico. In the investing world, the term often applies to initial public offerings. Comprehensively, the winner’s curse theory can be applied to any purchase done through auction.

As most investors know, intrinsic value is usually quantifiable but situations and subjective factors make value estimates more unclear in real-time and real life.

Theoretically, if perfect information was available to everyone and all participants were completely rational in their decisions and skilled at valuation, a fully efficient market would exist, and no overpayments or arbitrage opportunities would ever occur. However, while efficient markets are helpful to understand in theory, historically they have proved to be unachievable 100% of the time.

Thus, emotions, irrationalities, rumours, and other subjective factors can push prices far beyond their true values.

At its core, the winner's curse is a combination of cognitive and emotional friction. Unfortunately, the winner’s curse is usually most often recognized after the fact. The buyer is victorious in owning whatever asset they are bidding on. However, the asset is likely worth far less in resale value after ownership due to different factors affecting the purchase and influencing its value in the future.

Overall, when an individual has to bid more than somebody else to get something, there is a good chance they end up paying more than they had wished, but it's often only after the transaction has taken place that they see this.

Dr. Wilson was the first to study this matter. The rational bidders may decide to underpay for resources in order to avoid the ‘winner’s curse’, and Dr. Wilson argued that sellers can get better bids for their goods if they share more information about it with potential buyers

Auction Formats

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.

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.