Nobel for using game theory to fortify auction market participants

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By Sankar Ray

The Series Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (considered as Nobel Prize for Economics) for 2020 to 72-year old Paul R. Milgrom and 83-year-old Robert B. Wilson of Stanford University for the 2020 is for their contribution to Auction Theory, precisely “for improvements to auction theory and inventions of new auction formats”- dealing with how people act in auction markets, aside from research investigations into the properties of auction markets.

It is not only a recognition for their solution for sellers who are keen on providing as much information as possible before the bidding begins, thus offering the option for independent appraisals, but it paves the way for use as a tool to inform the design of real-world auctions; most notably auctions for the privatisation of public-sector companies or the sale of licenses for use of the electromagnetic spectrum. Wilson is professor emeritus at the Stanford Graduate School of Business, Milgrom is a professor in the university’s School of Humanities and Sciences .The prize money is 10 million Swedish krona ($1.12 million).

To illustrate the format and its application, consider an auction for a natural resource like a tract of timber. Bidders there may have different costs of harvesting or processing the timber. These costs may be independent across bidders much like in the above model. But they are ‘likely to be unsure exactly how much merchantable timber is on the tract, and use some sort of statistical sampling to estimate the quantity. Because these estimates will be based on limited sampling, they will be imperfect – so if i learned that j had sampled a different area and got a low estimate, she would likely revise her opinion of the tract’s value. In addition, if the areas sampled overlap, the estimates are unlikely to be independent.’

Their discoveries have benefited all – sellers, buyers and taxpayers the world over .People look up to the highest bidder while selling things, or buying them from whoever offers the cheapest ,especially when objects worth astronomical sums of money change hands in daily auctions – not only household objects, art and antiquities, but also securities, minerals and energy. Even public procurements too..

Auctions are transactions with a specific set of rules detailing resource allocation in sync with participants’ bids and categorised as games with incomplete information because in the vast majority of auctions, one party will possess information related to the transaction that the other party does not (e.g., the bidders usually know their personal valuation of the item, which is unknown to the other bidders and the seller). “Auctions ask and answer the most fundamental questions in economics: Who should get the goods and at what prices?’’ stated Peter Cramton, a former student of Wilson’s now at the University of Maryland and the University of Cologne in Germany.

Auction Theory is the standard reference on auctions and the first source of authoritative information about multi-unit auctions. “The new auction formats are a beautiful example of how basic research can subsequently generate inventions that benefit society. Auctions are everywhere and affect our everyday lives,” the Royal Swedish Academy of Sciences observed. Refreshingly enough for the academia, never was the award was confered to a scholar (Wilson) and one of his doctorate students (Milgrom). Milgrom’s mentor is Wilson.

Wilson used game theory for establishing the best bidding strategy in common value auctions, and showed how it leads to low bids as people are afraid of the “winner’s curse”, the uncertainty about paying too much and losing out — overestimating the common value and winning the auction at too high a price. The basic approach insulates transactions from speculative propensities and vagaries thereof. “They applied auction theory to more realistic settings. Their basic research allowed them to invent entirely new auction formats. ,”said Peter Fredriksson, an economist at Uppsala University and chair of the Nobel committee on economic sciences.

In the 1960s and 1970s, research on auctions focused on each person’s private or subjective evaluation of the goods or services for sale. But underlying most auctions is a common value—a market price that bidders ought to share estimate independently. Milgrom, Wilson’s graduate student, added to this framework by showing how both private values and common values influence the auction outcomes. The two applied economists along with Preston McAfee, are best known for the so-called simultaneous ascending auction, which was developed for the U.S. Federal Communications Commission’s 1994 sale of spectrum, to set prices on electricity and gas and the like.

The FCC applied the Auction Theory to better allocate radio frequency bands to telecom and media companies. Previously it used to allocate spectrum using licence applications and random lotteries. By using Milgrom and Wilson’s auction format, designed to counter the problems of uncertain values and the winner’s curse, the new FCC spectrum auctions drove billions of dollars in sales over the next twenty years. Thereafter the format has been adopted by other countries—including the UK, India, and Canada—to improve their allocation of not just radio frequency bands, but also other assets like carbon emission allowances.

Using auction theory, researchers try to understand the outcomes of different rules for bidding and final prices through the auction format. The analysis is tough, since bidders behave strategically, based on the available information. They take into consideration both what they know themselves and what they believe other bidders to know.

Wilson developed the theory for auctions of objects with a common value which is uncertain beforehand but, in the end, is the same for everyone. He showed why rational bidders tend to place bids below their own best estimate of the common value. Milgrom formulated a more general theory of auctions that not only allows common values, but also private values, varying among bidders. He analysed the bidding strategies through 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 during bidding.

“We need well-thought-out systems, and part of what we do in market design is try to think about all of the aspects of systems — competition, distribution, solving hard, complex problems,” quipped Milgrom, pointing out that poor market design contributed to the early ventilator bottleneck because states were forced to bid against each other for available equipment without ever expanding that product’s supply. And the hard reality is that societies have allocated ever more complex objects over time among users, like landing slots and radio frequencies. The new formats are meant for auctioning off many interrelated objects simultaneously, for a seller motivated by broad societal benefit rather than maximal revenue. (IPA Service)

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