A useful starting point is to recognize that auctions can have a wide array of formats. Most people are used to the idea of an auction where an auctioneer presides over a room of people who call out bids, until no one is willing to call out a higher bid. But auctions don\’t need to work in that way.
In short, there is no single perfect auction. Instead, thinking about how auctions work means considering for any specific context how auction rules and format in that situation, given what determines the value of the auctioned objects and what what kind of information and uncertainty bidders might have.
The 1991 U.K. sale of television franchises by a sealed-bid auction is a dramatic example While the regions in the South and Southeast, Southwest, East, Wales and West, Northeast and Yorkshire all sold in the range of 9.36 to 15.88 pounds per head of population, the only—and therefore winning—bid for the Midlands region was made by the incumbent firm and was just one-twentieth of one penny (!) per head of population. Much the same happened in Scotland, where the only bidder for the Central region generously bid one-seventh of one penny per capita. What had happened was that bidders were required to provide very detailed region-specific programming plans. In each of these two regions, the only bidder figured out that no one else had developed such a plan.
In a multilicense U.S. spectrum auction in 1996–1997, U.S. West was competing vigorously with McLeod for lot number 378: a license in Rochester, Minnesota. Although most bids in the auction had been in exact thousands of dollars, U.S. West bid $313,378 and $62,378 for two licenses in Iowa in which it had earlier shown no interest, overbidding McLeod, who had seemed to be the uncontested high bidder for these licenses. McLeod got the point that it was being punished for competing in Rochester and dropped out of that market. Since McLeod made subsequent higher bids on the Iowa licenses, the “punishment” bids cost U.S. West nothing (Cramton and Schwartz, 1999).
Notice that the bids from U.S. West ended in the number 378, which was the lot number where the company wanted McLeod to back off.
The auctions that most people participate in are \”private-value auctions,\” where the issue is just how much do you want it–because you are planning to use it rather than to resell it. In this setting, a live auctioneer tries to get people emotionally involved in how much they want something, and in this sense to get them to pay more than they had perhaps planned to pay beforehand. As Ambrose Bierce wrote in his Devil\’s Dictionary published back in 1906: \”AUCTIONEER, n. The man who proclaims with a hammer that he has picked a pocket with his tongue.\”
In most auctions, the bidders have both private and common values. Suppose you are thinking about bidding in an auction for an apartment or a house; your willingness to pay then depends on your private value (how much you appreciate its condition, floor plan and location) and your estimate of the common value (how much you might be able to sell it for in the future). An energy company that bids on the right to extract natural gas is concerned with both the size of the gas reservoir (a common value) and the cost of extracting the gas (a private value, as the cost depends on the technology available to the company). A bank that bids for government bonds considers the future market interest rate (a common value) and the number of their customers who want to buy bonds (a private value). … The person who finally cracked this nut was Paul Milgrom, in a handful of papers published around 1980. … This particular result reflects a general principle: an auction format provides higher revenue the stronger the link between the bids and the bidders’ private information. Therefore, the seller has an interest in providing participants with as much information as possible about the object’s value before the bidding starts. For example, the seller of a house can expect a higher final price if the bidders have access to an (independent) expert valuation before bidding starts.
In addition, Milgrom has participated in setting up new kinds of auctions. When auctioning radio spectrum to telecommunications providers, for example, how much you are willing to bid for rights in one geographic area may be linked whether you own the rights in an adjoining area. Thus, rather than auctioning off each geographic area separately–which can lead problems of collusion between bidders– it makes sense to design a Simultaneous Multiple Round Auction, which starts with low prices and allows repeated bids across many areas, so that geographic patterns of ownership can evolve in a single process. There is also a Combinatorial Clock Auction, in which bidders might choose to bid on overall “packages” of frequencies, rather than bidding separately on each license. Milgrom also was a leading developer of the Incentive Auction, which the Nobel committee describes in this way;
The resulting new Incentive auction was adopted by the FCC in 2017. This design combines two separate but interdependent auctions. The first is a reverse auction that determines a price at which the remaining over-the-air broadcasters voluntarily relinquish their existing spectrum-usage rights. The second is a forward auction of the freed-up spectrum. In 2017, the reverse auction removed 14 channels from broadcast use, at a cost of $10.1 billion. The forward auction sold 70 MHz of wireless internet licenses for $19.8 billion, and created 14 MHz of surplus spectrum. The two stages of the incentive auction thus generated just below $10 billion to U.S. taxpayers, freed up considerable spectrum for future use, and presumably raised the expected surpluses of sellers as well as buyers.
The economic theory of auctions is clearly tied up in intimate ways with the practice and design of real-world auctions. More broadly, close analysis of buyers and sellers in the structured environment of auctions can also offer broader insights into how non-auction markets work as well. After all, in some ways a competitive market is just an informal auction with sellers offering bids hoping to get a higher price and buyers making offers hoping to get a lower price.
For more from Milgrom and Wilson on auctions and related economics, here are some articles from the Journal of Economic Perspectives, where I work as Managing Editor.
- Milgrom, Paul. 1989. \”Auctions and Bidding: A Primer.\” Journal of Economic Perspectives, 3 (3): 3-22.
- Milgrom, Paul. 2008. \”What the Seller Won\’t Tell You: Persuasion and Disclosure in Markets.\” Journal of Economic Perspectives, 22 (2): 115-131.
- Roth, Alvin E., and Robert B. Wilson. 2019. \”How Market Design Emerged from Game Theory: A Mutual Interview.\” Journal of Economic Perspectives, 33 (3): 118-43.