Auction Theory and Why is it so important

Auctions had been a means of carrying out trade and commerce from time immemorial. The ancient traders would sell their shipment of goods to the highest bidders. Traditionally auctions followed two formats, the English Auction wherein the bidders would bid from low to high and Dutch Auction wherein a highest price is set and it is lowered in stages till a buyer is found.

In modern society objects worth very high value change hands every day in auctions, not only household objects, art and antiquities, but also securities, minerals and energy. Public procurements can also be conducted as auctions. This had led to development of complicated auction theory in 1960s which tried to understand the modus operandi of bidders in a particular auction situation.

Lets take an example. The Government of India regularly auctions mobile telephonic bandwidth to the service providers through a bidding process. Now the Government may have one or the other objectives. The first objective may be make mobile penetration high in the country with affordable prices. The other objective may be to maximise revenues. If the Government follows the first objective the auction strategy may be less on price and more on which company can ensure better penetration at affordable costs for consumers. In the second strategy the entire focus is on revenues. So in the first objective a variant of English bidding may be used and in the latter a variant of Dutch auction may be used. The bidders would also behave differently.

The Royal Swedish Academy of Sciences awarded this year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel — popularly, albeit incorrectly, referred to as the Nobel Prize for Economics — to Paul R Milgrom and Robert B Wilson. Both winners are currently with Stanford University, where they teach in different departments.

The Academy notes “ Robert Wilson developed the theory for auctions of objects with a common value – a value which is uncertain beforehand but, in the end, is the same for everyone. Examples include the future value of radio frequencies or the volume of minerals in a particular area. Wilson showed why rational bidders tend to place bids below their own best estimate of the common value: they are worried about the winner’s curse – that is, about paying too much and losing out. Paul Milgrom formulated a more general theory of auctions that not only allows common values, but also private values that vary from bidder to bidder. He analysed the bidding strategies in 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.”

Wilson specifically developed the theory of Winners Curse syndrome wherein each rational bidder would bid lower than the perceived value of an object in order to avoid overpaying to win. They are afraid to win by paying too much which in their minds is akin to losing.

Every year, as auctions became more and more complicated with billions of dollars changing hands Wilson and Milgrom developed newer formats that showcased how to arrive at a broad societal benefit rather than private revenue maximisation.