THE THEORY BEHIND AUCTIONS:
ARE THEY AS OSTENSIBLY SIMPLE AS THEY APPEAR TO BE?
On 12th October 2020, I woke up to see the following lines plastered all across news media — “The 2020 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was awarded to Paul R. Milgrom and Robert B. Wilson for ‘improvements’ to auction theory and inventions of new auction formats”. The two American economists, both professors at Stanford, were recognised for their work in auction innovations that provide crossover applications for the allocation of scarce resources. They would equally share the 10 million Swedish kronor award money as well as the lifelong prestige this honour afforded them.
What exactly are auctions? What is Auction Theory? What are the implications of Prof. Milgrom and Prof. Wilson’s work on Auction Theory? What is it about their research that caused them to win the ‘Nobel in Economics’? These are some of the questions that arose in my mind, when I first read about it — and this is an attempt to answer some of these (albeit bold, to assume that I have any authority to give my opinion on such ground-breaking work, but an attempt nonetheless).
How do we decide the “value” of any commodity? This is one of economics’ deepest mysteries that has successfully managed to perplex generations of economists. More often than not, we know that a commodity is worth a certain amount because everyone agrees on its “monetary value”. However, what happens when everyone doesn’t agree on the value of the commodity? What if a contention arises? How is it finally settled? One way to solve the problem would be to hold an auction.
When I hear the word “auction”, I think of the original World War 2 Enigma Cipher machine that was auctioned by Sotheby’s in 2017 for a whopping $435,000. (I also think of Britney Spears’ used Chewing Gum that was put up for an auction on eBay in 2004, and later sold for 14,000 USD — but that’s a weird one, so let’s just pretend I didn’t mention it, and move on). Generally, when we think of an “auction”, we think of an open-outcry, ascending-bid (English) auction. However, this kind of auction is just one among many.
Auctions date back a long time. The historian Herodotus described men bidding for the most attractive wives in Babylon, almost 2,500 years ago. Thus, we can consider the auction to be approximately as old as the marketplace itself. Fundamentally, an auction may be defined as an economic mechanism whose purpose is the allocation of goods, and the formation of prices for these goods is done via a process known as bidding. Auction design is a careful balance of encouraging bidders to reveal valuations, discouraging cheating, and maximizing revenues; and lies at the crux of psychology and economics.
William Vickrey was the first to establish the taxonomy of auctions. His categorisation was based on the order in which the auctioneer quotes prices and the bidders tender their bids. He established four major (one-sided) auction types: the ascending-bid (English) auction; the descending-bid (Dutch) auction; the first-price, sealed-bid auction; and the second-price, sealed-bid (Vickrey) auction.
One might question the necessity of having so many canonical auction forms. However, all four auction types result in an identical level of revenue to the seller only under very strict assumptions. The first assumption is that the asset being auctioned has an independent and private value to all bidders. This assumption often holds when the item is for personal consumption. However, it does not hold when bidders perceive a value of resale. The second assumption is that all bidders are risk-neutral. The strict definition of risk neutrality is: given the choice between a guaranteed return and a gamble with an equal expected return, the bidder is completely indifferent. The bidder who prefers the guaranteed return is said to be “risk-averse,” while the other is said to be “risk-loving.” These assumptions are quite restrictive and rarely hold.
Auction Theory may be understood as the applied branch of economics that provides us with a tool to understand the design of auctions, the rules that govern them, the behaviour of bidders and the achieved outcomes. In the modern world, auctions are everywhere (in fact, every time we search something on Google, the advertisements we see alongside the search results are present because they won a complex auction). If auctions are well designed, they result in significant benefits to the economy and society. An auction’s design has a significant impact on its outcome. William Vickrey shared a Nobel memorial prize in 1996 in part for his foundational work on the theory of auctions. However, Vickrey’s work, while phenomenal in itself, does not give economists the tools to analyse complex, practical auction design problems that real-world issues require. Professor Wilson and Professor Milgrom have provided pioneering insights in this regard.
In what has now come to be known as the “Wilson Doctrine” and revolutionised the field, Professor Wilson stressed on the importance of accepting that bidders never have complete knowledge, while using insights from game theory to design auctions for the real-world. Subsequently, he became one of the first researchers to design auctions that could be used for complex real-world issues. Professor Milgrom’s famous theoretical paper explained what the optimal auction design would be for a commodity, in which some information about the good is commonly known, and some information is privately held. He found that auctioneers could increase their revenue if they shared more information with bidders.
Another famous insight of auction theory is the “winner’s curse”. It is the idea that an item in an auction is won by the person who overvalued it the most. Someone might win an item (say Britney’s chewing gum) with a $14,000 bid. However, if the person below them bid $13,500, they could have won the item while paying almost $500 less. Prof. Wilson showed that because bidders were scared of paying too much, they tended to place bids below what they thought was the “common value”, i.e. they assumed that the item for sale is worth the same to everyone.
Professor Wilson and Professor Milgrom’s work aided economists in being viewed as designers who were called on to design specialised auctions, in order to find the values of complicated phenomena. Furthermore, their work transformed the ways in which countries can allocate resources (including logging rights and mineral exploration rights among others), in the public interest. Governments have turned to auctions over the past few decades to allocate resources, against the alternative which was to hand them out cheaply to political favourites, which was hardly in the public interest.
For decades of revolutionary and ground-breaking research, that provided pioneering insights into the field of auction theory and benefited society as a whole, the Laureates were recognised by the Royal Swedish Academy of Sciences in 2020 as the joint winners of the Sveriges Riksbank Prize in Memory of Alfred Nobel.
REFERENCES:
https://www.econlib.org/library/Enc/Auctions.html
https://www.cityam.com/nobel-prize-in-economics-what-is-auction-theory-and-why-is-it-important/
https://www.ft.com/content/878bcc02-1e4d-4b88-a137-0ad1ddcc92e5
https://www.abc.net.au/news/2020-10-16/why-auction-theory-won-two-americans-a-nobel-prize/12771764
