A ‘Nobel’ reward for auction designers

Kala S Sridhar/V Sridhar | Updated on October 20, 2020

Professors Robert B. Wilson and Paul R. Milgrom of Stanford University   -  REUTERS

Paul Milgrom and Robert Wilson have brought path-breaking innovations in the design of auctions

Governments world over now use the auction method to sell public assets such as telecom spectrum. The credit of making auctions popular must go to Paul Milgrom and Robert Wilson, who have been awarded this year’s Nobel in Economics for their pioneering work on auction design.

Auction as a form of sale and purchase is quite old. From time immemorial, bankrupt people’s assets were auctioned to pay their creditors and clear their debt. It is basically a method to sell assets of heritage value, in a way that maximises their economic benefit to sellers, although buyers also have a number of advantages such as getting access to highly valued items at a price they deem appropriate.

They also set their own value for the item and bid in a competitive setting, winning of course only if their bid is the highest for the asset. Several governmental auctions and tenders (termed by Milgrom as ‘sealed bid auctions’) go by the lowest bidders to award their projects, such that cost is minimised.

‘Winner’s curse’

So the ‘winner’s curse’ is such that the winner happens to be the one who is willing to pay the maximum for the prized asset, or if in a sealed bid, the lowest for executing a project. This was the case with a young contractor in Karnataka who tried to ‘bag’ road projects with an initial lower bid, undercutting others, so that he could gain ‘experience’ in executing projects.

Milgrom suggested that one could get around the winner’s curse by marking up the cost the next time after winning the lowest bid, as his/her lowest bid would have been an underestimate of the actual cost. So, looking back, Milgrom’s theory showed that the returns from bidding arose from information and cost advantages. But being careless in bidding could cause bidders to lose money, even though they may have ‘won’ the project in principle.

In real world policy-making, urban development authorities sell their land by auction to the highest bidder to maximise the economic benefits, to which Milgrom referred in his empirical examples of the winner’s curse.

The Mumbai Metropolitan Regional Development Authority (MMRDA) won a whopping ₹23 billion way back in 2007 by auctioning off three plots of land in the Bandra-Kurla complex, which was more than twice the investment made by the then Mumbai Municipal Corporation in the city’s infrastructure.

The Bangalore Development Authority (BDA) always auctions off its ‘corner sites’ with its revenues from auction sites being a whopping 46 per cent of its total revenues as early as 2007-08.

Numerous such examples abound from cities such as Jaipur, Ahmedabad, Kolkata, Gurgaon and Hyderabad. Even globally, Egypt auctioned desert land to finance new cities. Turkey auctioned its old municipal bus station to collect $1.2 billion in proceeds.

The other most widely used application of auction theory is telecom spectrum which has been a major revenue earner for countries around the world.

Way back in 1994, Milgrom and Wilson, along with Preston McAfee, proposed to the Federal Communications Commission the conduct of the first ever Simultaneous Multiple Round Ascending Auction (SMRA) as the mechanism design for allocating radio spectrum for commercial mobile services in the US.

Activity rule

The auction resulted in the sale of 900 MHz spectrum for Personal Communication Services, which fetched the government exchequer more than $1 billion in revenue. However, at the same time, the price per MHz was around $27 million, very much higher than the price being witnessed in current auctions. Milgrom devised many design innovations in SMRA including the famous “activity rule”, which required bidders to be active early in the bidding to maintain eligibility to bid later, thus avoiding “sniping”.

Versions of the activity rule are now widely used in auctions around the world including the ones that are conducted in India. To make the spectrum allocation process efficient and to allow for possible complementarity and substitutability of licensing regions, the US Federal Communications Commission introduced a packaged auction, again on the advice of Milgrom in the mid-2000s, the first one being Auction 73 in the allocation of 700 MHz spectrum band. The auction history in the US is not complete without mentioning the incentive auction that was conducted over a period of 13 months during 2016-2017, the mechanism design of which was pioneered by Milgrom.

The process started with a reverse auction that facilitated broadcasters to relinquish voluntarily their spectrum rights in the upper end of the 600 MHz spectrum band (about 14 Ultra High Frequency TV channels), followed by a forward auction in which the relinquished spectrum rights were sold to telecom operators and Internet Service Providers for providing mobile broadband services.

Thanks to Milgrom and Wilson’s mechanism design, the first SMRA was conducted in India in 2010, wherein 2100 MHz and 2300 MHz spectrum were allocated. This auction resulted in 183 rounds over 34 days, yielding a total revenue of $16 billion to the country’s exchequer.

Subsequently, the SMRA was held in India every year during the 2012-2016 period. In the 2016 auction, the government netted more than ₹50,000 crore.

Unfortunately, the success of this auction became a stumbling block for the success of future auctions as the price discovered in this auction was set as the reserve price for subsequent auctions by the government.

As Milgrom points out, auction may not be the most appropriate method to sell a good if the timing of all individual demands is not the same, the item is durable (unlike something like fish) and individual bargaining may be deemed more feasible, as in the case of goods found mostly in supermarkets.

Given these wide ranging applications of the theory, Milgrom and Wilson thoroughly deserve the Nobel Prize for Economics for their ground breaking work on auctions.

The authors are faculty at the Institute for Social and Economic Change and the International Institute of Information Technology, Bangalore. Views are personal.

Published on October 20, 2020

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