This Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2020 has been awarded to Paul R. Milgrom and Robert B. Wilson “for improvements to auction theory and inventions of new auction formats”.
They are worthy recipients of the highest honour in economics. It is, as is often noted, not actually a Nobel Prize and was critiqued by Hayek in his acceptance speech for bestowing authority above station (see Paul Krugman). Nevertheless, Milgrom and Wilson show how theoretical insights in economics can deliver immense human benefit. Auctions have ancient roots, but their ideas provided new insights and applications.
Wilson developed a bidding model for perfect competition. He argued that in a closed auction (in which other bidders cannot see each other’s bids) the highest bid will be equal to the true value. This reveals the common value, leading to a mutually beneficial equilibrium outcome without requiring sharing of information in advance between seller and buyers (as is often the case to resolve game theory problems).
The bidding process extracts the information unknowable in advance to the seller. “Thus, no bidder knows the true value of the item, yet it is essentially certain the seller will receive that value as the sale price,” Wilson writes. This supports the idea that a sale price conveys the relevant information, that sale price is equal to the value of the product, and that prices are meaningful in a competitive market.
On the other hand, Milgrom theorised that auctions not only allow the revealing of a common value but also differing private values between bidders. By analysing various bidding strategies across auction formats, Milgrom concluded that revenues are higher when bidders can learn about each other’s bids.
Milgrom and Wilson didn’t just write the theory, they helped engineer new action formats. They worked with governments to develop new, multi-stage auctions that, by increasing information flows, created pressure to maximise the value of public assets.
Milgrom and Wilson’s ideas were first used by US authorities in 1994 to develop an auction format to sell radio frequencies in a “simultaneous ascending auction”. This model was copied by the UK Government in 2000 to auction the 3G mobile phone spectrum. They used multiple secret rounds, in which a bidder had to be active in each round, either holding their bid or raising the bid by at least the minimum increase. Only after each round were the bids revealed. There were 150 rounds over a six-week period. Bidding closed when there were no new bids on any licence. The sale raised £22.5 billion, four and a half times more than was anticipated, and up until that point, “the biggest auction ever”. At the time it was 2.5% of GDP for “selling air” and enough to build 400 new hospitals. (Spectrum subsequently divided in price: the 5G auction in 2018 raised “just” £1.4 billion.)
Learning from this experience, the Adam Smith Institute has long argued that auctions could have even wider applications. We have called for auctions for work visas after Brexit, airport take off and landing slots as well as low-altitude airspace for air taxies and autonomous freight drones, reverse auctions for train subsidies, privatising state-owned companies, and rezoned property to raise money for infrastructure and compensation.
The alternative to auctions are ‘top-down’ administrative processes, in which government bureaucrats – who lack information about the respective uses – specify arbitrary criteria and opaquely select a winner. These processes are not only less efficient but can also be corrupt and do not raise revenue.
For example, if we choose to allocate radio spectrum by an administrative process, who would decide whether Three or Vodafone deserve a certain frequency? Or perhaps a radio or television service? How do we know whether companies are being truthful about how much they value the frequency? What would be the influence of lobbyists from the respective companies?
Auctions are a sensible tool when there are multiple potential uses of a scarce resource. Actions reveal value and ensure an efficient allocation: whoever is willing to bid the highest in an action are showing they would get the most value relative to the other potential users.
Thanks to Milgrom and Wilson we now understand this all quite a bit better.