Free exchange – The Nobel prize in economics rewards advances in auction theory

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    IN 1991 ALVIN ROTH, who in 2012 would share the Nobel prize for economics, was asked how the discipline might change over the century to come. “In the long term”, he wrote, “the real test of our success will be not merely how well we understand the general principles which govern economic interactions, but how well we can bring this knowledge to bear on practical questions of microeconomic engineering.” Sweden’s Royal Academy of Science seems to agree. On October 12th it gave this year’s Nobel prize to Paul Milgrom and Robert Wilson, both of Stanford University, for their work on auction theory and design. Their work epitomises economics as engineering.

    Auctions are an ancient mechanism for selling valuable commodities, from fine art to a fisherman’s catch. A few, simple forms of auction have been dominant over time. In an English auction, ascending bids are made until a winner remains; in the Dutch variety, a high opening price is set and is reduced until a bidder is found. Yet as their use has expanded, auctions have become more complex, and economists have taken a keener interest. In the 1960s William Vickrey, who shared the Nobel in 1996, developed what became known as auction theory. He assessed bidders’ optimal strategies and studied the revenue and efficiency properties of different auction formats. But Vickrey concentrated on a relatively narrow set of cases, in which each bidder’s valuation of the good being sold is unrelated to those of the other bidders. In practice, however, what one person believes an auctioned item to be worth often depends on the valuations of other bidders or the seller. Each may have private information about its value, clues to which are revealed in the course of the auction.

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    Mr Wilson began analysing such cases in the 1960s. He first tackled scenarios where the item for sale has a “common value”—a value that is uncertain beforehand but, in the end, is the same for everyone. An example might be a plot of land with oil beneath it, where participants may have different estimations of its value, perhaps because each has varying estimates of the quantity of oil. In such cases, the winner often discovers that the information others had about the common value led them to make lower bids. This may mean that the winner overestimated the worth of the item and paid too much, a phenomenon known as the winner’s curse.

    Mr Wilson’s work in this vein laid the groundwork for the analysis of yet more complex scenarios, which take both bidders’ unique private valuations and estimates of an item’s common value into consideration. The value of an oilfield, for instance, might depend on both the quantity of oil in the ground and how cheaply each bidder can extract it. Mr Milgrom (whose doctoral thesis was supervised by Mr Wilson) derived a number of important lessons from his analyses. Auction structures that elicit more private information from bidders—such as English auctions, where every participant observes who bids what and who drops out—reduce the winner’s curse problem compared with formats where very little private information is divulged. In some cases, it may be in the seller’s interest to provide bidders with more information about the item under the hammer.

    Much like Mr Roth, who helped design market mechanisms to match sick patients with kidney donors, Messrs Milgrom and Wilson put the knowledge gained from their theoretical work to practical use. Before the early 1990s, America’s government used unwieldy methods to allocate portions of the radio spectrum to interested telecoms companies. Bidders either explained why they deserved a slice of spectrum more than others (and spent vast sums of money on lobbying), or were allocated slices through lotteries. Neither led to an efficient allocation. In 1993 Congress allowed the Federal Communications Commission to use auctions instead. Yet it was not clear how these might work. Bidders had wildly varying assessments of how slices of spectrum might be used, and the value of one piece of spectrum often depended critically on what other parts an owner also controlled. The laureates worked with another economist, Preston McAfee, now at Google, to invent a new format, known as the “simultaneous multiple-round auction” (SMRA). Participants may bid on all items in a number of rounds, after each of which some information about bids and prices is revealed to the bidders. When first used in 1994, SMRA raised $617m for an American government that had previously earned almost nothing from its distributions of spectrum rights.

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    SMRA-style auctions are now used routinely in many countries and in contexts other than spectrum sales—in selling electricity, for instance. Questions of distribution have continued to motivate the prizewinners’ research and led to the development of other specialised auction formats. Messrs Milgrom and Wilson became the embodiment of the economist as engineer, using theory to devise a solution to a practical problem. It is an approach Sweden’s Royal Academy of Science seems to admire. This year’s award is the third since 2007 to honour “mechanism design”, or the use of economic principles to design markets to solve real-world problems.

    The economist’s lot

    The pursuit of economics as a form of engineering means that Messrs Milgrom and Wilson are more enmeshed in the real world than the typical academic. Both have consulted for regulators and firms. Mr Milgrom advised Time Warner and Comcast on their participation in radio-spectrum auctions in 2006; his efforts helped save his clients more than $1bn. In 2009 he co-founded a firm, Auctionomics, that provides consulting services to those looking to operate and to bid in auctions (many of the sort designed by the prizewinners).

    It is a different sort of work from that which many aspiring scholars imagine themselves to be pursuing. But the rewards the laureates have reaped in academia and beyond certainly advertise the power wielded by economic engineers.

    Correction (October 13th 2020): An earlier version of this article incorrectly said that the Riksbank awards the prize for economic sciences. It is in fact Sweden’s Royal Academy of Science; the Riksbank helped establish the prize. Sorry.

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    This article appeared in the Finance & economics section of the print edition under the headline “Winning bids”


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