The Auctioneer’s No-bell Prize in Economics

Governments all around the world were sitting on assets more precious than most mining right contracts and it was not until 1994 in the US that this realization dawned upon them. The US authorities realized that their earlier mode of allocating spectrum bandwidth licenses I was failing miserably. The FCC (Federal Communications Commission), prior to 1994, allotted these licenses using lottery and holding hearings to determine which telecom company had the best interests of public at heart. This method of allocation of licenses, basically for free, ironically, was never in the best interests of the public as it denied the government exchequer billions of dollars – money which was then obtained from taxpayers. Till date, the spectrum auctions have made the US treasury around USD 100 billion richer.1 The 1994 US spectrum auction was famously dubbed as the “greatest auction in history”, and for the right reasons, because in 1994 alone, USD 7.617 billion were raised by selling licenses.


Auctions: What are They?

The auction that most of us know about is the kind you’d find in the IPL or for the History TV18 nerds, Baggage Battles and Storage Wars - a chaotic, loud arrangement with a rapper for a bidder, where buying decisions are made frantically and items are sold quickly. However, that’s just one of the many forms of auction formats, called the “English Auction”. A broader definition of an auction may be “an economic mechanism whose purpose is the allocation of goods and the formation of prices for these goods via a process known as bidding”.3 There are multiple ways of conducting an auction based on factors such as number of goods, discoverability of bids, ascending or descending progression of bids, determination of final price, etc. On these bases, we can identify four major kinds of auctions:

  1. English Auction: As described above, the bids are in an ascending progression, i.e. every subsequent bid is higher than the previous one, there is a minimum reserve/base price and the winner is the one whose bid is the highest (i.e. nobody is willing to bid higher then them).

  2. Dutch Auction: Here, the auctioneer starts from a price higher than her estimation of the value of the product and invites bids lower than that. The auctioneer keeps reducing the price until someone accepts that price and the item is sold to that person. Characterised by a descending progression of bids, it is a very fast-tracked form of auction and used when speed is of the essence.

  3. First-price, Sealed-bid Auction: As opposed to most other auctions, this one does not let you know about bids being made, the identity of the bidders and the price they’re willing to pay. The betters submit their single best bid in a sealed envelope and the highest bidder gets the item being auctioned. This kind of auction is carried out in the case of high-profile real estate sales, financial instruments, etc.

  4. Vickrey Auction: This is another kind of sealed-bid auction. The difference is that in the previous type, the price to be paid by the highest bidder was the price she quoted as her own bid, whereas here the price to be paid by the highest bidder is the second highest bid made. For example, if A wins an auction by bidding $10 to acquire an item and the second highest bid is B’s at $8. The winner is A but she will pay $8 (the second highest bid) and not $10. It’s a theoretically sound concept but happens rarely in the real world.

Simultaneous Multiple Round Auction:

The above formats of auctions have their own drawbacks which became apparent when the FCC was planning to conduct its 1994 spectrum auctions. This marks the entry of Robert Wilson and Paul Milgrom, the joint winners of this year’s Sveriges Riksbank Prize in Economic Sciences. Together, they suggested a new auction format called “Simultaneous Multiple Round Auction (SMRA)”. SMRA is an extension of the English Auction, in which all items are put up for bidding simultaneously, as opposed to individually in the latter. Bidding is conducted in various rounds, with the highest bid in each round becoming the opening bid for the next round. The winner is the person who holds an identical highest bid in two consecutive rounds. The level of availability of bidding information varies, but at least the price of the current highest bid is revealed, which helps other buyers to estimate an appropriate valuation of the item being sold in case they don’t have complete information. The buyers have to bid for the items they wish to acquire simultaneously and they will not be eligible to bid on an item in the subsequent rounds if they do not bid on it in the current round.


Why Did the SMRA Work?

Since SMRA is an extension of English Auction, it is essential to establish why the English Auction is better than Vickrey, Dutch and First-price Sealed-bid auction. The central problem with Vickrey and First-price Sealed-bid Auction is that there is no information with the bidders as to what the other bids are. This lack of information creates the fear of the winner’s curse3. Bidders who do not have information about the actual value of an item will be fearful of bidding high in case they over-estimate the real value of the item being auctioned, i.e. to avoid the winner’s curse. The problem with Vickrey’s Auction specifically is that it can lead to manipulation in the form of dummy bids being made by players merely to drive the price up for a competitor. This is possible because the final price for the highest bidder will always be the second highest bid and hence the highest bidder’s payment will depend on the other bids. A similar incident occurred, as Preston McAfee, Distinguished Scientist at Google and former Chief Economist at Microsoft recounts in a video with “Numberphile”, a YouTube Channel, “When I was at the Department of Justice, a bidder submitted a bid that contained copies of all their rivals’ bids in the same envelope”4. The possibility of collusion, manipulation and cheating becomes amplified in sealed-bid auctions, specifically Vickrey’s Auction. In Dutch Auction, the bidders simply get no new information during bidding, since the first bid made is the highest bid and that’s that. This will restrict players with incomplete information from even placing a bid, let alone winning it, denying potential profits to the seller.


Since we have established why the English Auction is superior to the rest, we need to understand what improvements Milgrom and Wilson made to English Auction to make it such a huge success. The SMRA is different from an English Auction on two accounts:

  1. Simultaneous Bidding of All Items: Simultaneous bidding is especially useful in spectrum auctions because it prevents a strategic player from acquiring specific geographical licences that will block another player’s entire network, which eventually leads to the first player selling the spectrum second-hand to the second for a higher price. Since the outcome of future auctions is unknown, buyers can’t accurately estimate the real value of the items being sold in the beginning, since it will depend on whether they acquire the license for the other locations which complete their network. Individual bidding eventually creates a mandatory second-hand market, and nobody is willing to bid aggressively in the actual auction. Simultaneous bidding hence ensures that buyers bid on all licences that they need simultaneously.

  2. Activity Rules: This is a very important aspect of SMRA, wherein bidders are supposed to bid on the items they wish to acquire from the first round itself. They can’t employ a “snake-in-the-grass” strategy, wherein they jump in all of a sudden on an item on a subsequent round and bid on it. Activity rules prohibit such strategical moves, which result in a loss to the seller and disrupt the efficiency of the auction. A final price must always be the closest estimate to the real value of the item for an auction to be efficient and such negative strategies hinder that. Hence, activity rules are essential.

While the SMRA has been highly acclaimed through the years, there are certain problems with it. This is not to say that Milgrom and Wilson’s work was for nothing. Their work in the field of auction theory is commendable and has been imbibed by multiple nations across the world, including Brazil, India, UK, Germany, etc. Their inventions and theories opened the doors for multiple better auction formats to be developed as successors of the SMRA, and their contribution to telecommunication and game theory in general is unparalleled.


Definitions:

  1. Spectrum Bandwidth Licence: A spectrum license is permission given by a government agency (such as the U.S. Federal Communications Commission) to an entity that gives that entity exclusive rights to use a frequency band for a particular application, such as radio broadcasting. Licenses are designated for a specific geographic area, such as rural areas, metropolitan areas, regions, or the entire nation.

  2. FCC (Federal Communications Commission): The Federal Communications Commission regulates interstate and international communications by radio, television, wire, satellite and cable in all 50 states, the District of Columbia and U.S. territories.

  3. 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. As a result, the largest overestimation of an item's value ends up winning the auction.


References:

  1. https://priceonomics.com/the-spectrum-auction-how-economists-saved-the-day/

  2. Press release: The Prize in Economic Sciences 2020. NobelPrize.org. Nobel Media AB 2020. Sat. 17 Oct 2020. https://www.nobelprize.org/prizes/economic-sciences/2020/press-release/

  3. https://www.econlib.org/library/Enc/Auctions.html#:~:text=He%20established%20four%20major%20(one,%2Dbid%20(Vickrey)%20auction.

  4. https://www.youtube.com/watch?v=4kWuxfVbIaU

by Soumil Agarwal (soumilagarwal@gmail.com)


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