On October 12th, 2020, Stanford University professors Paul Milgrom and Robert Wilson won the Nobel Prize in Economic Sciences for their contributions to auction theory, a branch of economics that explores how auctions shape prices, how auction participants behave, and how auction design can achieve optimal or efficient outcomes. Often associated with game theory, the usage of auctions can be dated back to ancient history when the Greeks would put women on auction for their hand in marriage, or when the Romans would auction off spoils of war [1].
Modern auctions have evolved to become more socially agreeable; from the purchase of commodities to making purchases on eBay. Although there are a significant number of variations, a typical auction starts with an auctioneer placing an item on sale. Potential buyers compete for the item, bidding their own prices against one another, in progressive elevation. Often, auctioneers may have a reserve price, either disclosed or undisclosed to bidders, which is the lowest price the auctioneer is willing to sell the item for. In the end, the highest bidding price wins. This variation is commonly known as an English auction, or an open outcry ascending dynamic auction.
Auctions are permeated throughout interactions across the globe. Whether you are bidding for exclusive clothing online, participating in a share buyback, or buying fish at the market; the average individual will undoubtedly come across auctions in their lifetime. The ultimate question is, how are auctions linked to economics, and how can we navigate the world through the lens of auction theory?
A perfect example of an English auction is often observed in the Australian property market, where open-outcry auctions are used to put houses on sale in real time to a flock of eager homebuyers. Housing market prices are determined by several factors, such as the property size, the value and utility of the surrounding suburb, or the macroeconomics of housing demand and supply. Auctioneers, often real estate agents, start the auction with a bidding price, and people compete to set a higher price that they are willing to pay for the property. This continues until a buyer bids a price that no one else is willing to compete with, and the result is an economic equilibrium; an unchallenged price that both the buyer and the seller are happy with. Of course, the landowner has a minimum price they are willing to sell the property for, and the auction can be ‘passed in’ or withdrawn from the auction at the time if this price is not met. It would be rare to observe any other auction format other an English one in everyday life, for they are simple and applicable to all sorts of market situations.
However, there are auction designs that are better suited to certain situations than others. For instance, whilst an English auction may work best for selling single items, it can be more appropriate to use other auction mechanisms when large quantities of identical items are involved, such as financial products. A Dutch auction, for example, is often used with company IPOs, where a company can raise capital by setting a high ask price for their shares. An investor will enter the ‘auction’ through the underwriting investment bank, receiving a prospectus and other information involved in the offering. As usual, investors specify the quantities they want to buy and at what price during bidding. The auctioneer, i.e., the underwriter, will decrementally lower prices until enough bids for all offered shares are made. The shares are then sold at the highest price that investors are willing to pay for given all shares available will be sold [2].
On a commercial or industrial level, auctions can become slightly more nuanced. For example, telecommunication providers participate in spectrum auctions, which involves selling transmission rights on limited electromagnetic spectra – to acquire designated network coverage on certain radiofrequencies, allocating them to services such as mobile networks. Furthermore, electricity companies often compete in reverse auctions – one buyer with multiple sellers – to sell electricity business contracts to company clients that are looking to procure a fair market price for electricity plans. On the other hand, governments may use auctions to sell carbon emission permits to organisations and reduce the effects of climate change.
Nobel Laureates Milgrom and Wilson were celebrated for their focus on making auctions more efficient and exploring how auctions can determined the fair value of prices. Their quest was to find how one could enter auctions strategically, and how tactics and behaviours alter based on the auction design. If you were bidding for a painting and had to reveal your perceived value of the painting to all other bidders, how would you optimise your strategy knowing others will compete against your value? Alternatively, if you were participating in a sealed-bid auction where all values are kept private, how would your strategy change, knowing that you cannot learn what values your competitors hold?
These kinds of questions are important because if answered well, they could help us allocate resources in a more cost-effective way, create efficient auction markets, or prevent irrational behaviours occurring in auctions that are innately designed to encourage irrationality, such as the winner’s curse.
“The most optimistic bidder often overestimates the common value of an auctioned object, so that ‘winning’ the auction turns out to cause a loss – the winner’s curse”
What Milgrom and Wilson particularly worked on was spectrum auction optimisation. How can an auction be designed to efficiently allocate radiofrequencies to telecommunication providers whilst also benefitting taxpayers? Well, the design of the ‘simultaneous multiple round auction’ (SMRA) in place of sequential auctions proved to be a significant improvement, such that the Federal Communications Commission in the United States began using the SMRA auction design to sell radiofrequencies in 1994. Over the past 20 years, more than $200 billion USD has been generated from spectrum sales of this kind alone, with other nations around the world adopting the very same system [3]. With the sale of spectra more efficiently conducted, governments could thus possess more disposable revenue to spend on other areas in the public sector.
It is highly recommended to delve deeper into Milgrom and Wilson’s research achievements in your own time, which can be briefly examined here.
So, let us shift slightly to the current situation. While the COVID-19 pandemic persists, governments have continued to spend freakish amounts of money on physical capital, human welfare, and economic recovery. There is absolutely no doubt in mind that there have been just as many wasteful policy decisions made as there have been economical ones. This begs the question: could auction theory have any significance in navigating ways to better allocate resources or make business decisions in a time such as this? It could in fact be more intuitive than you think.
Let us affirm the definition of a finite resource as anything with a rate of consumption that is exceedingly quicker than its rate of production. What finite resources are most essential in a time like this? Here is a quick non-exhaustive list: vaccines, medical personal protective equipment, ventilators, hospital beds, maybe even toilet paper at some point. Clearly, the healthcare sector is an easy place to start. Then, how could we perhaps allocate vaccines efficiently? Who gets them first? Should we base these actionable policies on economics, or ethics? Well, the possibility for vaccine auctions has had a modest share of research [4] [5], and proposals range from generating a wealth spillover effect and herd immunity through a charity auction design, to implementing a ‘Vickrey-Clark-Groves mechanism’ – basically a multiple-item sealed-bid auction – with a twist of allowing bidders to bid on the behalf of both themselves and others. To explore deeper may take a bit more brainpower, so we will leave it at that, but it is sufficient to grasp that there are fascinating ways in which auction theory can impact the direction of policy, even in situations as peculiar as the pandemic.
For governments across the globe, including Australia, auction theory is becoming increasingly relevant in determining the appropriate distribution of public resources and shaping the decisions that have the potential to influence both entire industries and common individuals. Auctions that are customised and designed to befit different situations have the capacity to display a level of transparency, cost-efficiency, and objectivity to various problems that is arguably much better than plain, clerical processes. The auctions we have described are far beneath the complexity that one would see in other assumptive or theoretical circumstances, but that is not a sign of discouragement to go further down the rabbit hole. In the same way as business and commerce continue to evolve, so too does auction theory in efforts to provide explanations and solutions to the inefficiency problems that arise. It has never been a better time to explore the practical applications of auctions, as well as game theory, in solving some of the most mundane or most pressing issues existing in the world today.
[1] Auction Room (2019). a short HISTORY of auctions. ABC TV. Retrieved from https://www.abc.net.au/tv/auctionroom/about/auction_history.htm
[2] Corporate Finance Institute (2021). Dutch Auction. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/dutch-auction/
[3] Nobel Prize (2021). Popular information – The quest for the perfect auction. Retrieved from https://www.nobelprize.org/prizes/economic-sciences/2020/popular-information/
[4] Thaler, R. (2020). Getting Everyone Vaccinated, With ‘Nudges’ and Charity Auctions. The New York Times. Retrieved from https://www.nytimes.com/2020/12/09/business/coronavirus-vaccination-auctions-celebrities.html
[5] Pancs, R. (2020). A Vaccine Auction. SSRN Electronic Journal. doi: 10.2139/ssrn.3746231