This year's Nobel Prize in Economics went to Paul Milgrom and Robert Wilson "for improvements to auction theory and the invention of new auction formats." Humans have recorded auctions in various ancient cultures from at least 2,500 years ago, so why do we need new formats? In this post, I will outline the ways the world has changed, talk about the winner's curse and then outline Milgrom and Wilson's Nobel Prize-winning work.

Traditional auctions

We commonly think of auctions as starting with the auctioneer soliciting bids that begin at a low price, and then each bid ascends in value until there is one bidder left. Colloquially we call ascending bidding an English Auction. There's another kind of auction where the price starts high and then descends in value until the first bidder claims the goods and this is colloquially called a Dutch Auction. Either of these formats works quite well when you're only bidding on simple goods like potatoes, but there is a problem with them.

The Winner's Curse

The traditional English and Dutch auctions have what is called the winner's curse where the top bidder always pays above the market rate. Why is that? Well, imagine Alice has purchased a painting by outbidding Bob (English/ascending bids). Essentially the market price of that painting is what Alice paid, but should Alice try to sell that painting then she cannot claim that same value. Instead, Alice has effectively lost the difference in value between her winning bid and the next highest bidder. Dutch (descending bid) auctions also have the winner's curse, but because the first bidder wins, it is not as easy to quantify what the value lost is because there are no other public bids to compare to.

The winner's curse manifests in other ways during auctions; incomplete information and getting caught up in the moment can all make it difficult for the bidders to gauge and act according to the intrinsic value of an item. But why is the winner's curse bad? Well, the winner's curse can lead to buyers remorse where the winning bidder feels as if they have overpaid and so buyers might be shy about bidding in future or even collude to keep the bids low.

Despite the winner's curse, traditional format auctions persist because they are quick, simple, and useful.

Hot take: Art auctions allegedly exploit the winner's curse for fun and profit.

A changing world

The world has changed a lot in the millennia since auctions began. For one thing, modern auctions are often for multiple items where the value of them are interrelated. For a simple example imagine that Bob wants to purchase the ingredients to bake a cake, now the ingredients singly are worth nothing to Bob because he is only interested in purchasing if he can assemble enough ingredients to make a cake. Charlie the savvy counter-bidder might detect that Bob is trying to purchase cake ingredients and then outbid Bob on the last ingredient. Charlie can then sell the last ingredient to Bob knowing that Bob's only option is to either buy the final ingredient from Charlie or materialise the losses from his winner's curse by trying to on-sell the other cake ingredients. This situation causes Bob to waste resources in trying to mask his actions and to bid lower than he otherwise might on individual ingredients.

Maybe Bob has alternatives to the cake ingredients. Perhaps Bob is happy to bake a cake or to make a vegetable stew. In this situation, it may be harder for Charlie to counter-bid, but Bob is stuck with a situation where he might end up with two incomplete sets of ingredients. This would cause Bob to bid even lower.

Radiofrequency spectrum auctions

Bob's cake and stew scenarios are trivial in our days of plentiful supermarket shopping; to accept those examples, the items being auction must be scarce. One such modern situation is the auctioning of the radiofrequency spectrum which grants licenses to operate a particular frequency band in a defined geographical region. Many providers, notably mobile providers, would prefer to have the same frequency band in as many regions as possible. When these auctions were held in a traditional format, the winner's curse came into play; There were Charlie counter-bidders and shy bidding Bobs.

The innovation

By recognising the winner's curse and the problems with traditional auctions, Milgrom and Wilson were able to innovate different auction formats. One such innovation is the Simultaneous Multiple-Round Auctions (SMR) where multiple items are auctioned at once but in multiple rounds until there is only one bidder per item. Typically the bids are kept secret until the end of each round, at which point bidders can increase their bid or withdraw.

An SMR auction limits the impact of a Charlie counter-bid because Bob can back out of all of the other interrelated bids leaving Charlie holding the bag. So, by limiting the ability of Charlie, there will be less of them, and so Bob is less shy about bidding. In the beginning, Bob can bid on both his cake and vegetable ingredients and withdraw the other bids once he has secured a complete ingredient set.

This important contribution was put into practice in the 1994 Spectrum auction in the USA. It has since been used in other areas.

Summary

Humans have been buying and selling by auction for millennia, and there are some problems with the traditional formats we use; most notably the winner's curse. These can result in situations where bidders are shy and bid less. Also, in modern times, there are situations where the value of items to a bidder are inter-related, and in extreme cases has an all-or-nothing preference. Bidders are vulnerable to counter-bidders who buy up one of the items.

By recognising the winner's curse and other traditional auction problems, Paul Milgrom and Robert Wilson innovated on auction formats and came up with the Simultaneous Multiple-Round auction. This limits the impact of counter-bidders and reduces shyness. The auction format has been used in Radiofrequency Spectrum auctions since the 1990s. Congratulations on the Nobel Prize for noteworthy practical and theoretical contributions to economics.

Until next time.

Credits

• Official Nobel Prize Announcement
• Headline image Pixabay.com / klimkin Free for commercial use