The Hindu explains | What have the 2020 Nobel Laureates in Economics discovered about auction theory?
The story so far: US economists Paul R. Milgrom and Robert B. Wilson, who both teach at Stanford University, received the 2020 Nobel Prize in Economics last week. This year, the Sveriges Riksbank Prize in Economics in Memory of Alfred Nobel was awarded to the duo “for improving auction theory and inventions of new auction formats”. The Nobel Prize committee noted that Dr Milgrom and Dr Wilson not only came up with original ideas in auction theory, but also played a crucial role in the implementation of their ideas.
What is auction theory?
Auction theory is a branch of economics that deals, as the name suggests, with auctions. Auctions are important to economists because they are the most widely used and also the most efficient mechanism for allocating scarce resources. The allocation of scarce resources, in turn, is important to economists because there is a finite supply of resources on earth compared to unlimited human needs, and therefore, they should be allocated only to the most urgent needs of the world. society. In particular, auction theory deals with the different ways in which auctions can be designed to improve seller income, increase consumer benefits, or even achieve both of these goals at the same time.
How is this relevant?
Throughout history, countries have tried to allocate resources in various ways. Some have tried to do this through political markets, but this has often led to biased results. Think about how rationing of essential goods works in various state-controlled economies. People close to the bureaucracy and the political class got ahead of the rest. Lotteries are another way to allocate resources, but they do not guarantee that scarce resources are allocated to the people who value them the most.
Auctions, for good reason, have been the most common tool used for thousands of years by companies to allocate scarce resources. When potential buyers compete to buy goods at an auction, it helps sellers find buyers who value the goods the most. In addition, selling goods to the highest bidder also allows the seller to maximize his income. Thus, buyers and sellers benefit from auctions.
What are its applications?
Auctions take place almost everywhere in the modern world. Even the sale of groceries in retail stores is auction-based, although it is implicit and relatively slow to adapt to changing market conditions. For example, a supermarket manager, just like an auctioneer, tries to price his products based on the quantity sold in a certain day, week or month. If there is a huge demand for a certain product and the shelves are empty quickly, the supermarket manager will increase its price to avoid a shortage. If another product does not sell as quickly as expected, its price may be lowered to eliminate any unsold inventory.
More sophisticated and explicit auction mechanisms are used for the allocation of capital goods such as spectrum and minerals. But whether it is the spectral wave auction or the sale of fruits and vegetables, auctions are at the heart of the allocation of scarce resources in a market economy.
What are the contributions of economists?
To understand the contributions of Dr Milgrom and Dr Wilson, it is important to take note of the criticisms leveled against the auctions. Most commonly, auctions can cause buyers to overpay for resources of uncertain value to them. This review, popularly known as the “winner’s curse,” is based on a study that showed how buyers who overpaid for US oil leases in the 1970s achieved low returns. Dr. Wilson was the first to study this question. He found that rational bidders may decide to underpay for resources in order to avoid the “winner’s curse,” and argued that sellers may get better deals for their products if they share more information to this topic with potential buyers. Mr Milgrom added an additional nuance to this analysis by arguing that individual bidders can always submit very different bids due to their unique circumstances. A company that can sell oil at a higher price or process it at a lower cost, for example, may be willing to pay more for crude oil.
Second, economists traditionally working on auction theory have believed that all auctions are the same when it comes to the income they have managed to bring to sellers. The format of the auction, in other words, didn’t matter. This is called the “income equivalence theorem”. But Dr Milgrom has shown that the auction format can actually have a huge impact on the revenue that sellers earn.
The most famous case of an auction gone bad for the seller was that of the spectrum 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 offer, one The company that offered NZ $ 1,00,000 ultimately only paid NZ $ 6 and another that offered NZ $ 70,000,000 did not paid that 5,000 New Zealand dollars.
In particular, Mr Milgrom showed how Dutch auctions, in which the auctioneer lowers the price of the product until a buyer bids, can help sellers earn more income than UK auctions. In the case of UK auctions, the price increases based on higher bids submitted by competing buyers. But as soon as some of the bidders withdraw from the auction as the price increases, the remaining bidders become more cautious about bidding higher prices.
Dr Milgrom and Dr Wilson, however, are most popular for their contributions to the design of new auction formats in the real world. Combinatorial auctions designed by the duo, for example, have been used to sell complex products such as spectrum as lots, rather than as individual units. Previously, governments sold spectrum rights on an ad hoc basis, making them unattractive to companies that demanded spectra in a beam. This led to private speculators making billions in the secondary market by reselling spectrum, while the government was deprived of revenue it could easily have earned with better auction design.
How important are these contributions?
The contributions of Dr Milgrom and Dr Wilson have helped governments and private companies to better design their auctions. This, in turn, contributed to a better allocation of scarce resources and increased the incentive for sellers to produce complex goods.
In fact, Auctionomics, a company co-founded by Dr. Milgrom, helps businesses and governments design auctions, adding to other innovative auction formats adopted over the centuries by sellers trying to maximize their income. Finally, not all economists necessarily agree with the popular use of Dr Milgrom and Dr Wilson’s work on the ‘winner’s curse’ auctions. They argue that while enthusiastic bidding can reduce business performance, it won’t necessarily lead to higher prices for consumers, as is commonly believed. Indeed, in any competitive market, the pricing of consumer goods is based on what the market will bear, rather than sunk costs. In addition, a persistent one-upmanship is unlikely as financial losses wipe out inefficient speculators over time.