Auctions are exciting – a live ongoing fierce competition with people bidding to win a prized asset. It is common for items of art and historical importance to be auctioned; however, auctions have been more commonly used in selling items such real estate property, commodities, minerals, etc. since a long time. The concept has gained increasing significance in business transactions over the years, as it is one of the best ways of securing a fair market price for the product. On one hand, the banks and financiers auction properties and stock when a borrower fails to repay loans; meanwhile, eBay took the auction concept to a whole new level when it started online auctions. Auctions are so beloved that now even humans are auctioned legally in sports leagues and illegally in human trafficking!
Over the years, as the world has become complex, auctions have also grown complicated. Now we have coal mines, oil fields, exploratory sites, mobile frequencies, advertising space, etc. being auctioned to the highest bidder besides the traditional commodities. While the conduct of auction proceedings remains the same, the complexities involved in the product turns even a winning bid, into a curse – commonly referred to as ‘The Winner’s Curse’.
Let’s take coal mines for example. Coal extractions are approved when necessary, and the quantity of coal to be extracted from various mines is declared. However, the coal which is yet to be extracted is auctioned off to the highest bidder even before the mining takes place. Now this is blind bidding, although research, trials, reports and historical results can help the bidder with the certain prior knowledge to bid, however, the buyer is still not sure what grade of coal will be extracted – it can be of the highest quality or degraded quality with little end-use. Accordingly, the supplier of coal might suffer losses or gains – it’s risky!
And it gets even further risky in case of oil fields where after a few trial drillings and geologic ultrasound analysis, the entire field is sold to bidders – “What if the trial happens in the best part of the cake, while rest all is devoid of oil or contains much little than expected?” It’s all about estimates and even after winning the bidding, the buyer might still end up losing a lot, as faulty predictions are quite a possibility.
What did the auction theorists achieve?
Paul Milgrom and Robert Wilson developed auction theories to overcome the winner’s curse. Wilson developed the theory to explain why in an auction of items with a common value, the bidders often offer bids lower than they think the object or service is worth of because they fear overpaying for the item – the winner’s curse. Milgrom, on the other hand, came up with his theory to explain why private values vary from bidder to bidder in an auction. When Wilson and Milgrom came together, they developed new formats of the auction to sell many inter-related items simultaneously.
The theories were also practically used in 1994 when the United States sold radio frequencies to telecom operators. On the success of the theory, the same was followed by many other countries to sell spectrums in their countries. Their theories also had a profound effect on the sale of advertisements in search engine and public auctions such as eBay. Their work was also used in financial trading which is also a type of auction over the internet, with bidders spread across the country. The laureates’, thus, not only devised the theory, but they also developed the practical applications of the same which is rare. Their theory of simultaneous auctioning of interrelated items is what won them the ‘Noble Memorial Prize for Economic Sciences 2020’.
How is the auction theory used?
When a seller wants to achieve the best outcome from selling an item through an auction, he must carefully design the format of auction. This is where the auction theory comes into use. Auction theories are used by researchers to develop auction formats so that the seller receives the best price for the product. The outcome of an auction usually depends on three main factors – the rules of the auction, the item being auctioned and the uncertainty involved in information.
The rules of the auction can allow open or closed bids, restrict the number of times a bidder can participate or allow free bidding, the winner can be expected to pay the highest bid or the second-highest one, etc.
Meanwhile, an auctioned object can have different perceived value for different bidders depending on the use, or it can have more the same value – the auction of PM Modi’s suit can have a high value for his supporters while less important for others.
The factor being key constraint is information, as the whole gamble surrounds it. The quantum of information a bidder has, the kind of information and the certainty of the information can cause the bidders to behave differently. The auction theory helps researchers to plan auctions accordingly considering the possible behaviour of various bidders.
About Paul Milgrom
72-year-oldPaul Milgrom is an American Economist and a professor for humanities and sciencesat Stanford University, who earlier worked as an actuary for several years. He is an expert in Game theory and specifically concerning auction theory and pricing strategies. He bagged Nemmers Award in 2008, BBVA Award in 2012 and Golden Goose Award in 2014 for his work related to game theory and auction theories. He had advised Google in its 2004 Initial Public Offering (IPO) and has also been an advisor for Yahoo and Microsoft.
About Robert Wilson
83-year-old Robert Wilson is also an American Economist and a professor for Management at Stanford University. He had completed his MBA from Harvard Business School and has been faculty at Stanford University since then. Wilson is known for his research and teaching in topics concerning the industrial organisation and information economics. His expertise in game theory and its applications are well known around the world. He bagged BBVA Award in 2015 for his work in auction theories.
About Nobel Memorial Prize in Economics
Nobel Memorial Prize was established in 1968 by the Bank of Sweden. The award is different from the Nobel Prize distributed by Nobel Foundation, as there is no Noble prize in economics, however, the Nobel Foundation recognizes the award and lists the same on its website along with Nobel Laureates. Noble Prize in Economics has significantly boosted the credibility of economics science, however, the same has been a matter debate.
Is Economics a Science?
Unlike physics or other sciences, economists cannot conduct laboratory experiments in some controlled environments. The theories and results of economics are often based on historical data and merely predict what a result might be. Therefore, economics has always been considered a ‘Social Science’ and not a science. Recognizing economics as social science helps us loosen its perception as hard facts, instead considering it as mere commentary.