How Nobel Laureates Milgrom, Wilson transformed auctions

What comes to mind when you think about auctions? Usually, auctions for fine art at galleries or player auctions at sports tournaments are the first things to come to mind.

Realistically, auctions are far more ubiquitous in our lives than we think (like for the advertisements we see while surfing the internet) and increasingly complex. For example, while some commercial sellers want to maximise profits in an auction, the government may want to auction government bonds or pollution permits to improve liquidity or reduce pollution respectively. This is where this year's Noble Prize-winning Paul R. Milgrom and Robert B. Wilson's contributions to auction theory and innovations in new auction systems become relevant and significant.

Economics is concerned with the efficient allocation of resources and auctions are usually an ideal way to do so. However, there are many problems associated with traditional auction formats (English-style, Dutch style, etc.) like the collusion between the bidders or asymmetric information resulting in overvalued or undervalued prices.

Imagine being asked to place a bid on a jar of coins in a hypothetical auction. Here, the "common value" of the jar (which in this case is the total value of the coins) is unknown to all the bidders due to a lack of information until the very end of the auction process. As a result, the winner of the auction overestimates the value of the auctioned item and pays a price much higher than the common value and suffers from what we call the "winner's curse".

To put it in context, this would be the same as paying Tk1000 BDT in an auction for a jar of coins worth Tk200 BDT. Mr Wilson's research identified and investigated such problems and laid the groundwork for further analysis by Milgrom using the "private value" as well as the estimated common value of the auctioned items. In our example, the private value would also include the benefits we would have gotten from the jar (using it to store other items) or from the spare change we'd acquire which would vary for each bidder.

It was Milgrom, who later showed through his analysis of traditional auction formats that the sellers in an auction can overcome the problems associated with the auctions and maximise selling price by providing the bidders with more information about the auctioned item so that they can better estimate the common value. This enabled both buyers and sellers to get their best price in an auction.

This led to the remarkable economic engineering of new auction formats for allocating aeroplane landing slots, electricity, carbon emission permits, fishing quotas, etc. which were based on the economists' theoretical research and adopted by the governments and auction houses of countries like the US, UK, France, Canada and India resulting for billions of dollars worth of transactions.

Notably, they engineered the "Simultaneous Multiple Round Auctions" or SMRA for the Federal Communications Commission (FCC) to better allocate the radio frequency spectrum licenses (used for telecommunication, radio and internet services) to telecom operators. Before the new format, the US government would allocate licenses based on subjective evaluations or lotteries which would not generate revenues for the taxpayers.

Similarly, the telecom operators were hesitant to participate in an auction system where the licenses were auctioned one at a time resulting in uncertainty about whether they can acquire the licenses for the rest of the complimentary regional spectrum licenses. This was because the telecom networks were willing to pay more for a handful of licenses in different regions than for each license.

The SMRA solved all of these problems by allowing bids for all items simultaneously and divulging information related to the auctioned item ( i.e. the top bids for the licenses) in each round of the auctions until there are no new bids which helped buyers better estimate the common value of the item and maximise the revenue for the government. In fact, when this method was first tried in 1994 by the FCC, the SMRA earned around $617M for the government from the sale of radio spectrum licenses.

This year's Noble Prize in Economics recognised the impact and the contributions both Stanford economists had made to the auctioning systems worldwide and auction theory which resulted in both increased revenue as well as social welfare (better allocation of pollution permits and higher revenue for taxpayers). Moreover, Mr Wilson and Mr Milgrom not only contributed to the theoretical realm of economics but also to the economic application of said theories which benefitted both buyers and sellers while promoting efficiency and transparency of billions of dollars of transactions.

The two economists shared a very special moment at 2 am in Palo Alto when Milgrom's PhD supervisor and neighbour, Mr Wilson rang his doorbell to tell him that he won the Nobel Prize. Later in an interview with Stanford about the Prize and their work, Mr Milgrom said, "It's so great. We're enthusiastic about what we do, we like it and it's exciting."