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Should we trust the Auction Theory for Recourse Allocation to businesses?

Auctioning has long been a staple method of purchasing goods or services, with many believing it is as old as the marketplace itself. While many may think that the usage of auctioning has declined over the past few decades, it has grown in importance regarding governments determining where to sell their resources. While most people understand the concept of a private value auction (based on people bidding what they believe the product is worth, with the most massive bid winning), there are other forms of auctions that are likewise important, yet more complicated. For example, if two people were to bid on the combined total of money between their two wallets, each only knowing the value of his/her own wallet and not knowing the whole puzzle. This distinction between auction types is important when analyzing the goods being auctioned: whether they are commodities like oil with a common value, or private values that vary in amount according to the bidder, such as art. In the 1990s, as the world became more globalized, countries began using an auctioning system to allocate resources such as logging rights, mineral exploration rights, and the right to use particular radio frequencies for television and mobile phones (Harford). With the continuation of technological innovation, the need for a better understanding of auctions was needed, and two American economists, Paul Milgrom, and Robert Wilson, created new improvements to auction theory along with inventing new auction formats that have better real-life applications, allowing more people to understand the science behind auctions (Smialek). Their work recently won them a Nobel Prize in economic science earlier this month and revolutionized government methods of allocating scarce resources. Milgrom and Wilson showed the world what auctions truly were: a trick. In creating a well-designed auction, bidders are forced to reveal their true estimates of a product’s value, effectively setting the price, almost as if it were a self-fulfilling prophecy. But in showing the world the science behind the trick, they also showed how to best utilize the action of the auction so that more would benefit based on the new formats that were created.

While there may not be an official date for the first auction, historians believed they were used as early as ancient Babylon to auction off attractive wives (Harford). Since then, auctions have been used in all sorts of forms, from official auctions with fast-talking auctioneers to negotiating a price in a marketplace. It wasn’t until 1990 that auctions first obtained a theory surrounding them, created by economist William Vickrey in 1996. Many loved how Vickrey used Game Theory to describe auctions, however they criticized that his work did not give economists tools to analyze intricate auction design that real-life application requires. Once Vickrey’s work inspired the nation to rethink auctions, many strove to utilize them more often, including the US Government. Before the 1990s, radio bandwidth was once allocated by “beauty contests” where companies would make a case for why they deserved it most, resulting in heavy lobbying (Smialek). This all changed when the Federal Government switched to an auction-based system with Milgrom and Wilson providing advice on fixing any problems. The auctioning system was going poorly until Milgrom and Wilson’s new format of auctioning was adopted in 1994. This format allowed simultaneous auctioning from different geographic areas among many bidders. By starting with low prices and allowing repeated bids, the FCC found that this method allowed them to sell more radio space while raising far more money (Milgrom). Other countries such as Britain, Canada, and Spain soon followed suit, and auctioning theory gained much more importance on the international stage, especially with the creation of spectrum articles around the turn of the millennia. 

Milgrom and Wilson were the first to create a framework for auctions with a common value and provided many insights that would revolutionize auctioning. One of these insights is the winner’s curse, where someone will offer less than their perceived value of an item because they are afraid of overpaying, especially when they believe they do not have all the information. Interestingly enough, Milgrom discovered that people would statistically fall victim to the winner’s curse theory and underbid in auctions that start with lower prices and increase (English auctions) than those with higher starting prices that are reduced (Dutch auctions)(Smialek). While this theory is important in deciding which auction to use for a certain good, the most renowned contribution these two economists made to the world is their new auction formats for complex situations, which includes the aforementioned US government’s radio frequency auction process. Joshua Gans, who was a former student of Milgrom, best sums up the importance of Milgrom and Wilson’s practicality: “Their theoretical work is impressive, but they realized that when the world got too complex, they shouldn’t adhere to proving strict theorems” (Harford). This action of seeing auctions as an open and changing process instead of seeing it as strict guidelines allows for auction theory to have even broader applications than what already exists, such as in the challenge of determining who will receive respirators early in the COVID pandemic. Milgrom stated that when the US utilized the “bottleneck approach,” where states chaotically bid on a small supply of ventilators, they effectively showed why market design matters, as auction theory would have solved the issue differently (Milgrom). As the world’s governments slowly move towards adopting the auction theory approach for resource allocation, Milgrom and Wilson continue to adapt theoretical auction theory by trying to better understand differing results of auctions to create better practical applications for these auctions. As Mr. Milgrom states during a news conference held after the Nobel Prize ceremony, “we need well-thought-out systems that incorporate all aspects of systems, such as competition, distribution, and solving hard, complex problems to continue forming auction theory into a practice that can be understood and used by anybody” (Smialek).

The advancement of auctioning theory is especially significant in recent years with the introduction to auction formats that can cover products that have long been dealt with differently. As more economists and policymakers better understand and utilize auctions, its usage comes into question regarding business and government relationships. While allocating specific resources to specific companies used to be handled through lobbying, many policymakers want to increase the usage of auctions for these allocations. This can lead to many companies no longer getting the contracts they had previously, and allowing new parties to come in and bid equally. As Chapter 7 of Lawrence and Weber’s Business and Society textbook illustrates the importance of public policy in regards to what a government will do to support its citizens and companies, policymakers still have yet to create any fiscal or monetary policies to promote auction theory to be more dominating in our domestic market (Lawrence). This is subject to change, however, as many more products are being sold through auctions. Products such as the right to emit carbon dioxide, deciding which environmental projects should receive subsidies, determining how much money should be loaned to the central bank in times of stress, and the sale of eclectic power within states now all fall under auction theory (Smialek). Even the internet infrastructure was decided through auctions, along with determining which ads you see every day online. Auctions are growing in importance, and it is up to us to understand the theory behind them if we wish to obtain rights in any of the examples listed above. While auction theory may be based on the fact it is a trick, this does not mean we should not learn how to use this trick to the best of our advantage.

Works Cited

Harford, Tim. “Winning Bid: How Auction Theory Took the Nobel Memorial Prize in Economics.” FT.com, Financial Times, 12 Oct. 2020, www.ft.com/content/878bcc02-1e4d-4b88-a137-0ad1ddcc92e5. 

Lawrence, Anne T., and James Weber. Business and Society: Stakeholders, Ethics, Public Policy. 15th ed., McGraw Hill, 2020. 

Milgrom, Paul R. Putting Auction Theory to Work. Cambridge University Press, 2010. 

Smialek, Jeanna. “U.S. Auction Theorists Win the 2020 Nobel in Economics.” The New York Times, The New York Times, 12 Oct. 2020, www.nytimes.com/2020/10/12/business/nobel-economics-paul-milgrom-robert-wilson.html.

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