The economic science behind Wilson’s and Milgrom’s Nobel Prize
Whether it is determining carbon emission credits, how much you pay on your electricity bill or how much bandwidth your smartphone carrier uses to transmit information, auctions play a large role in contemporary society. The government uses auctions to determine selling rights for timber, minerals, gas and radio frequencies and to sell securities, such as treasury bills, notes and bonds. Auctions are also a way that governments buy and sell goods and services.
Wilson and Milgrom’s research provided the blueprint for how these markets function, creating new and better auction formats that determine the prices of the everyday services that we all use. Beyond establishing the best prices for buyers or sellers, their work helps auctions create as much value as possible and encourages a system where important goods and services are awarded to the bidders who are best able to use or manage them.
Differences between auctions come down to two main elements: the format and the information available about what is being bought and sold. This information is not only what’s supplied to the bidders but also what information they signal to each other.
In three influential papers in the 1960s and 1970s, Wilson showed how rational auction bidders can overestimate the value of an item they are bidding on. This was the first auction theory framework to look at a “common value” scenario where the bidders collectively hold the same value for the object being auctioned, but without full information of its value. In these papers, Wilson examined the “winner’s curse,” which is the tendency for the winning bid to exceed the true worth of the item. The winner’s curse can also lead cautious bidders to undervalue an item – to avoid the curse – and becomes especially problematic when bidders have different private information about an item’s true value.
Around the 1980s, Milgrom established theories that encompassed common values and private values, which vary from bidder to bidder. In focusing again on the winner’s curse, Milgrom determined that English auctions – where the price starts low and is bid upward – are better at avoiding the winner’s curse than Dutch auctions – where the price starts high and is bid downward. This is because bidders gain more information about an item’s value during the course of an English auction, as other bidders drop out. In general, Milgrom found that more information about the object’s value, such as certificates of authenticity, expert appraisals or insights into other bidders’ estimated values, tends to result in higher revenue.
New auction formats
In the 1990s, the United States Federal Communications Commission (FCC) needed a new way to allocate radio frequencies. Access to these government-owned frequencies is sold to private actors, which are then able to efficiently utilize them for wireless communications, including phone calls and internet use. Previously, the FCC doled out access through applications and lotteries. As mobile phone use expanded, the processes became unreasonably costly to the government and unsatisfactory to the mobile service providers.
To address this issue, Milgrom and Wilson invented a new auction format, called Simultaneous Multiple Round Auction (SMRA). In these auctions, all biddable items are offered simultaneously and bidders can bid on any portion of the items. The bids start low, in order to avoid the winner’s curse, and the auction ends when no bids are placed in a round. The first SMRA auction in 1994 sold 10 licenses over 47 rounds, fetching $617 million.
Many governments around the world adopted SMRA auctions for their own purposes and further refinements have resulted in additional new auction formats. Among these new formats was the incentive auction, which Milgrom took the lead in developing in order to help the government repurpose radio spectrum from television to wireless broadband. The incentive auction has two parts: a reverse auction to procure the spectrum-usage rights and a forward auction to sell that spectrum. The incentive auction design was the foundation of the largest-ever spectrum auction in 2016, which resulted in the sale of 70 MHz of wireless internet licenses for $19.8 billion.