Advancements in Auction Theory – The Future?

By Yoanna Dimitrova

Paul Milgrom and Robert Wilson, two professors at Stanford University, have won this year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for the invention of the new auction formats as well as for further developments in auction theory and the noteworthy application of their research back in 1994. The award returns to a more traditional theoretical ground as the economists have been one of the lucky few to not only come up with the theory but to also apply their research. The Laureates’ major contribution to economic theory paves the way for future applications of various auction formats to curbing carbon emissions and allocating 5g spectrum rights. 

Auctions have a long history. More than 2,500 years ago, the historian Herodotus described men bidding for the most attractive brides auctioned off by their families in Babylon. Looking into the Latin origins of the word, “auctus” means “increasing” and relates to the English ascending bid auction, one of the auction types present nowadays. Auctions were used by lenders in Ancient Rome, whenever they had to sell confiscated assets from borrowers who were unable to repay their debts. Some of the world’s oldest auction houses, such as Stockholm’s Auktionsverk, were founded for the purpose of selling allocated property, while the oldest firm of fine art, Sotheby’s, started off with dispersing scarce and valuable books.

Nowadays, the word auction might bring to mind the high-end art auctions, yet that is not the only setting where they occur, as they have become part of our everyday life. From selling or purchasing something on the internet to buying property via an estate agent. Auctions have become a transparent way of acquiring goods and services and their outcomes matter not only to us but also to taxpayers and governments.

The tendency towards privatization of previously state-owned assets in the late 20th century happened worldwide and was most noticeable in the former Soviet Union states and its satellites. Revolution in public policy was necessary in order to disperse limited resources to companies and firms. In order to do that efficiently, auctions have become increasingly common nowadays. For example, our mobile phone coverage is largely dependent on the radio frequencies telecommunication companies have acquired through spectrum auctions (i.e. auctions held by governments in order to allocate and price spectrum rights). While on a larger scale, the European Union’s call for net zero-carbon emissions by 2050 has led to the creation of an emission allowance auction scheme in order to curb global warming. 

This year’s Laureates have given immense insights into auction theory – from the way auctions work to the behavior of participants (or the so-called bidders) within the framework. To understand the advancements in auction theory, there are several important factors taken in consideration whenever designing and holding an auction.

The first determinant is the auction’s rules, or the so-called design. Usually the success of an auction is judged by its design. The design specifies whether bids are open or closed, the number of times participants bid in an auction and the price the winner pays, which could usually be their bid or the second highest bid.

The second specification relates to the auctioned object or resource as it could have a different (i.e. private) value for each participant or have the same (i.e. common) value for all participants.

The third factor deals with uncertainty and the information participants hold about the value of the good or service that is being sold.

By using auction theory, it is easy to see how these three factors influence the strategic behavior of the bidders’ as well as the auction’s outcome. Theory also suggests that the design of an auction influences the amount of revenue generated. This year’s Laureates in Economic Sciences have made auction theory more applicable in practice through the creation of new, auction frameworks.

The U.S. Federal Communications Commission (FCC) auction of wireless bands of the electromagnetic spectrum is a useful illustration of auction theory in practice. The excitement around spectrum auctions peaked at the height of the dotcom mania when the U.S. and European countries auctioned their spectrum rights. Since the 1994, the U.S. Federal Communications Commission (FCC) has conducted 33 Simultaneous Multiple-Round auctions, the design of which was entrusted to Milgrom and Wilson at the time. The economists ‘saved the day as their theoretical design of auction theory provided a mechanism for the allocation of scarce resources such as the electromagnetic spectrum rights.

Their auction design had to enable the efficient allocation of Personal Communications Service (PCS) spectrum licenses – a permission given by a government agency that gives the rights to use radio frequencies for the provision of radio broadcasting and other services. Since the value of the licenses is determined by the number of potential bidders and their valuations, this common-valued good had a large and uncertain value. A well-designed economic auction mechanism had to then maximize revenue for the government agency as well as to encourage bidders to reveal their valuations and private information, while also preventing cheating and collusion.

The challenge in this scenario, however, pertained to the many licenses on offer as well as participants bidding for certain combinations. Some of the licenses were substitutes of one another or complements, hence for example holding licenses for broadcasting in two close geographical regions was more valuable than acquiring only one. The task of designing such an uncertain combinatorial auction proved demanding as other common types of auction designs might overlook those details.

The mechanisms previously in place were hardly in the public’s interest. They were lengthy, lacked transparency and most of the times the companies winning the lotteries were not the best suited to provide the service. A common agreement among economists, based not only on economic theory, but also on various countries’ experiences, suggested auctions to be the best way to reassign common scarce resources.

Governments have increasingly turned to auctions over the past few decades to allocate resources such as logging rights, airport landing slots and the set-up of (carbon) emissions trading systems.Wilson and Milgrom’s Multiple-Round auctions model has become a staple for spectrum allocation worldwide and their ideas of innovative auction design proved revolutionary.

In the face of climate change, further developments of auction theory and the design of new frameworks provide an opportunity to turn attention to allocation of carbon emission permits and rethink the existing emission trading schemes. Part of EU’s policy to combat climate change and curb emissions by 2050 is outlined in the EU Emission Trading System (ETS). As of now, around 57% of EU carbon permits are sold at auctions, while the remaining permits are distributed free of charge to industrial firms and airlines using the so-called grandfathering allocation system, which is based on the firms’ past emission levels. The design of the auction plays a prominent role for the success of desired outcome as auctioning can always allocation based on previous performance and abandon the status quo. If designed correctly, auctions can allocate permits so that the necessary emission reductions are achieved as well as the costs of those reductions – minimized.

The history of auctions demonstrates the large social benefits of good frameworks and the consequences of poor designs. Designing markets and auctions well was the major contribution of this year’s Nobel Laureates and will remain crucial in ensuring further carbon reductions in the future.

Further readings:

“The views expressed in this article are the author’s own, and may not reflect the opinions of The St Andrews Economist.”

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