What is Auction Theory?

Economy Oct 30, 2020

The 2020 Nobel Prize for Economics was awarded to Paul R Milgrom and Robert B Wilson for “improvements to auction theory and inventions of new auction formats”.

What is this ‘Auction Theory’ ? And why did they get this Award?

So, it’s about how Auctions leads to discovery of the price of a commodity and it studies how Auctions are designed, what do the bidders do, and what are the outcomes achieved.

The auction works like this - the highest open bidder getting the Item auctioned. Now, over the period of time more and more goods and services have been brought under auction. The nature of these goods differs sharply. Like a bankrupt person’s property, a spectrum for radio or telecom use, carbon dioxide emission credits or a spot market to buy electricity. So no one auction design fits all types of commodities or seller.

Even the purpose of an auction also differs with the commodity and the entity conducting the auction.

The key variables that determine the outcome of an auction are the rules, the commodity or service being and uncertainty.

The bidding behavior is likely to differ if the rules stipulate open bids as against closed/sealed bids. Similarly, bids are made one after another or everyone bids at the same time.

Secondly the commodity or service being put up for auction. In essence, the question is how does each bidder value an item. This is not always easy to ascertain. It is not always easy to ascertain. In terms of telecom spectrum, it might be easier to peg the right value for each bidder because most bidders are likely to put the spectrum to the same use. It’s also called the ‘common' value of an object.

The third variable is uncertainty, for example which bidder has what information about the object, or even the value another bidder associates with the object.

So, Wilson developed the theory for auctions of objects with a common value — a value which is uncertain beforehand but, in the end, is the same for everyone. He showed what the “winner’s curse” is in an auction and how it affects the bidding.

It is observed that it’s possible to overbid  $50 when the real value is closer to $25 and doing so, one wins the auction but loses out in reality.

Milgrom “formulated a more general theory of auctions that not only allows common values but also private values that vary from bidder to bidder”.

He scrutinized that the bidding strategies in a number of well-known auction formats, demonstrating that a format will give the seller higher expected revenue when bidders learn more about each other’s estimated values.

Both the winners, Paul R Milgrom and Robert B Wilson are currently with Stanford University, where they teach in different departments.

This article has been written by Yashovardhan Tiwary for The Paradigm

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