US auction theory pioneers win Nobel economics prize
In News
- The Royal Swedish Academy of Sciences awarded this year’s Sveriges Riksbank Prize in Economic Sciences to Paul Milgrom and Robert Wilson.
- The award is popularly (although incorrectly) referred to as the Nobel Prize for Economics.
- In its announcement, the Academy said the pair is receiving the award for improvements to "auction theory" and inventions of new auction formats.
About: Auctions
- An auction is usually a process of buying and selling goods or services by inviting bids (offered price).
- The oldest form of auction is one in which the highest bidder gets the property (or the commodity being sold).
- However, over time, and especially over the last three decades, more and more goods and services have been brought under auction.
- Public authorities offer airport landings slots and mineral rights via auctions. Global financial markets also operate on these principles.
About: Auction theory
- Essentially, auction theory is about how auctions lead to the discovery of the price of a commodity. It studies how auctions are designed, what rules govern them, how bidders behave and what outcomes are achieved.
- As auctions help to sell a variety of products, a single auction design does not fit all types of commodities or sellers.
- This is also true because the purpose of an auction also differs with the commodity and the entity conducting the auction.
- More often than not, private sellers want to maximise their gains while public authorities may have other goals in mind.
- For instance, when selling telecom spectrum, a government could either think in terms of maximising its revenues or aim at making telecom more affordable to everyone.
- How an auction is designed, therefore, has a tremendous impact not just on the buyers and the sellers but also on the broader society.
Variables that determine the outcome of an auction
- Three key variables need to be understood while designing an auction.
- First variable:
- The first variable is the rules of the auction. The bidding behaviour in an auction varies depending on whether the rules specify open bids or closed/sealed bids.
- The behaviour would also change in case of single bids versus multiple bids, or whether bids are made one after another or everyone bids at the same time.
- The first variable is the rules of the auction. The bidding behaviour in an auction varies depending on whether the rules specify open bids or closed/sealed bids.
- Second variable:
- The second variable is the commodity or service being sold in the auction.
- The important point over here is how each bidder values an item, which is not always easy to calculate.
- For example, in terms of telecom spectrum, it might be easier to find 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.
- However, this may not be the case with some other commodities, for example a painting. A particular person may derive considerably more “private” or personal value (just by looking at the painting) than some other person.
- In most auctions, bidders allocate both “common” as well as “private” values to the object being auctioned and this affects their eventual bids.
- The second variable is the commodity or service being sold in the auction.
- Third Variable:
- 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.
- Using auction theory, it is possible to explain how these three factors influence the bidders’ strategic behaviour and thus the auction’s outcome. The theory can also show how to design an auction to create as much value as possible.
- 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.
Contributions of Wilson and Milgrom
- The Academy noted that, Wilson developed the theory for auctions of objects with a common value — a value which is uncertain before the auction but, in the end, is the same for everyone.
- Wilson showed what the “winner’s curse” is in an auction and how it affects bidding. For example, it is possible to overbid — $50 when the real value is closer to $25. In doing so, one wins the auction but loses out in reality.
- He developed a theory explaining the tendency of successful bidders to place bids lower than their own estimate of the item’s value to themselves or other buyers, because they feared paying too much (due to winner’s curse).
- Milgrom came up with a theory to deal with a mix of common and private value, and he examined the role of winner’s curse in such instances.
- He demonstrated that an auction format will give the seller higher expected revenue when bidders learn more about each other’s estimated values during the bidding process.
- According to the committee, the pair’s “best-known contribution,”, is their work in designing new auction formats for complex situations, including the format that governments now use to allocate radio frequencies to telecom operators.
Impact:
- The work of the two economists, now plays a big part in setting the price of many everyday goods and services.
- The new designs developed by them have been particularly significant for allocating public goods, such as radio spectrum, fishing quotas and airport landing slots.
- The effects of their work can also be seen in online advertising, which is now sold through auction.
- Their insights can also help hospitals and governments trying to secure protective equipment during a pandemic, from competing against each other and raising up the prices.
- This was evident this year when a shortage of personal protective equipment and ventilators led to high prices.
About: Nobel Prize
- The Nobel Prize is a set of annual international awards given in recognition of academic, and scientific advances.The prizes are widely regarded as the most prestigious awards available in their respective fields.
- The will of the Swedish chemist, engineer and industrialist Alfred Nobel established the five Nobel prizes in 1895. The prizes in Chemistry, Literature, Peace, Physics, and Physiology or Medicine were first awarded in 1901.
- An additional award, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, was established in 1968 by the Bank of Sweden and was first awarded in 1969.
- Although not technically a Nobel Prize, it is identified with the award and its winners are announced with the Nobel Prize recipients.
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