2020 is not only the year of a massive global pandemic, it is also the year that auction theory won its second Nobel Prize in Economic sciences. To be more precise, the prize was won by Paul Milgrom and Robert Wilson, two professors at Stanford University, who won the prize for their contributions in making auction theory more practically relevant. Before that, in 1996, William Vickrey also won the prize for his documentation of a specific type of auction that later came to be known as the Vickrey auction.
Now, that sounds great, and thus very much deserving a closer look. In this three part blog-series on the 2020 Nobel prise in economic sciences, that is exactly what I will do.
In this first blog post, I discuss what auction theory is and why William Vickrey won the Nobel Prize for it in 1996. Then, two weeks later, I will release a post on why Milgrom and Wilson won this year’s prise and finally, in the third post, I will explore why the Nobel Prise in economic sciences is so controversial and is actually not considered a ‘real’ Nobel prise.
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Definition of an auction
Alright, before moving to auction theory, let’s establish what an auction is.
According to the Cambridge English dictionary, one popular definition of an auction is “a public sale in which goods or property are sold to the person who offers the most money.” That sounds simple enough, and a lot of you might already have an idea of what an auction looks like. You might be thinking about an art auction, where the price is slowly raised, people raise their hands and then the work of art is sold to the last bidder with the highest bid. You might also be thinking about that time when you bought a house and had to submit your bid without knowing how much others were bidding and wondering how much you should bid to get the house of your dreams at a reasonable price. Finally, some of you might have visited the famous Dutch flower auction, where the price is lowered until a bidder presses a button to buy the flowers at the current price.
And while these might look quite different, they are all examples of auctions that economists study. In fact, some of the earliest work that auction theorists did was categorising the most popular auction formats.
What are the most popular types of auctions?
The most popular, and well known auction the English auction. This type of auction is the one that is used for selling art. As you will see in a bit, in an English auction, the auctioneer starts the bidding process for an object at some starting price. Bidders will then shout, or raise signs, with ascending prices. As the price increases, more and more potential buyers will drop out, until only one is left. This buyer made the highest bid, and will thus be awarded the object at the price of the final bid.
Very similar to this is the Japanese auction. In a Japanese auction, the auctioneer will also start with some starting price, but, will then subsequently raise that price him or herself. As you can see in the next example, auctions named after countries are popular all over the world. Here you will see a cattle auction in the Japanese auction format, where the auctioneer starts with a starting price, looks for willing bidders holding up their hands and then sell to the last one remaining. The last bidder remaining will get the object at the price that was last mentioned by the auctioneer.
The Dutch auction is basically the reverse of a Japanese auction. Here, you see an example of a Dutch auction being used to buy fish in bulk. Again the auctioneer –which is often not a person, but an automated clock– will control the price movement. However this time, the price starts high and will go down until someone is willing to buy at that price. Then when the price a low enough, the highest bidder pushes a button and at that point, similar to the Japanese and English auctions, he or she will be awarded the fish.
Now what unites these auctions is that the behaviour of other bidders can be observed by everyone else. Especially for the English and Japanese auctions, you know exactly what others are willing to. For the Dutch auction, you only know what others are not willing to bid.
However, for next type of auctions you, as a bidder, don’t know anything about what the other bidders are doing because they are all submitting their bids in secret. This used to happen in the form of a piece of paper, sealed in an envelope. Therefore, these types of auctions are known as sealed bid auctions. With all sealed bid auctions there is an object for sale and there is a set time period at which potential buyers can submit their bids in secret.
The most popular sealed bid auction is the first price auction. This is the type of auction that is typically used for house sales. Say you want to sell your house, then it is quite common for several potential buyers to come and visit your house and then submit a bid to you via their real estate agent. Say that you get three bids for your house. One bid of 200.000 dollars, one bid of 190.000 dollars and one bid of 180.000 dollars. Given that they all have the cash on hand and seem like responsible buyers, you would typically offer your house to the person who made the 200.000 dollar bid. In other words, the person who offered the first price. Hence, the name: first price auction. The winner of the first-price auction will buy your house for 200.000 dollars.
Now, this is where the 1996 auction theory Nobel prise winner: William Vickrey comes in. He suggested that you might want to consider an auction type that is known as the second price auction. This type of auction is almost identical to the first price auction. Everyone made their sealed bids of 200.000, 190.000, and 180.000 dollars and the person who made the 200.000 dollar bid will again win the auction. However, the seemingly odd difference is that this person does not pay you the first price, but rather the second price. So this person will now pay you only 190.000 dollars.
Now that sounds kind of crazy right? Why would you ever want to go with the advice of William Vickrey? This is where auction theory comes in.
Why would you choose one auction type over another?
The first major question that auction theorists studied is: what type of auction you should choose if you want to sell something? In most cases your primary concern as a seller is that you want to get the best possible price for the object that you want to sell. And thus you want to know what type of auction is most suitable for that.
Here one of the most interesting insights for which William Vickrey won the Nobel in 1996 is that theoretically the type of auction you choose shouldn’t really matter because bidders will learn to adapt their behaviour such that the revenue the seller gets from any of these auctions should be roughly the same.
To understand why that is the case, it is important to understand the other question that auction theorists studied extensively, and that is: what is the best strategy for buyers who are bidding in an auction?
What is the best strategy for buying in an auction?
Here one of the major insights from auction theory is that in the Dutch and first price auctions, the best strategy is typically to bid lower than what you think the object is really worth. To see why, you have to imagine how other people will likely bid. They all have some sort of an idea of what the object is worth. And in many of these cases, the object has a worth that is largely universal because it can be easily re-sold. For example, the Dutch flower market is a wholesale market. So the bidders are typically shopkeepers. Therefore, flowers shouldn’t be bought so high that they cannot be sold for a profit to consumers anymore. We also know that these shopkeepers are all trying to make a small profit on these flowers and that this is likely to be roughly the same since the flower market is pretty competitive. So then, there must be some true value that is roughly the same for everyone at the auction. However, people are not entirely sure what that value is and so they will all try to estimate it.
Now, some bidders will likely have too low of an estimate and some will have an estimate that is too high. But, one thing in this auction is for sure, and that is that the person that has overestimated the price by the most, will win the auction.
However, this will only become apparent to the winner, after the auction was won and, thus most likely, the winner has to pay too much and will make a loss. This phenomenon is known in auction theory as the winners curse.
Auction theorists also predict that the winners curse effect is likely in first price sealed auctions. And indeed, in many scientific experiments with inexperienced bidders this effect emerged for both the Dutch and first price auctions.
Now, what is bad news for buyers is, of course, good news for sellers. And, going back to our house sale example, the logical conclusion would seem that as a seller, you should opt for a first price sealed bid auction.
Why Vickrey won the Nobel prize in 1996
However, then you forget about one important thing, and that is that people will adapt their behaviour to suit the situation they are in. Thus, buyers will likely learn that by bidding what they think the house is worth, they will end up with the winners curse. So, auction theorists predicted that the best strategy for the Dutch and first price auctions was to always bid below what you think an object is worth.
And, indeed while the winners curse effect was observed in auctions with inexperienced bidders, the effect tended to disappear with more experienced bidders. So much so, that if there was uncertainty about the true price, these auctions even tended to produce prices just below what the object was worth because bidders were trying so hard to avoid the winners curse.
Now, at this point, you might wonder, is there also a winner’s curse effect for the second price and English auctions? No, not really, because in both cases, even if you bid at your estimate of the true value, you will always pay below well below that. And because you have to balance the risk of not getting the object with the risk of paying too much, auction theorists have shown mathematically that in many situations the best strategy here is just to bid the price you think the object is worth.
And because this reduced risk for buyers makes people more comfortable in bidding, these auctions typically yield more for the sellers of objects. That is why both Ebay and Google use second price auctions to sell objects and advertisements respectively.
Example of a Vickrey auction
Alright let’s apply that knowledge to our house price example. If you opted for the second price auction, the incoming bids will likely not have been 200.000, 190.000 and 180.000 dollars. Because bidders didn’t have to worry about this winners curse, it is more likely that the bids were 210.000, 205.000 and 190.000. Sure, the highest bidder would have payed the second highest price. But because that bid would have still been 5000 dollars more than the highest bid in the first price auction, following Nobel prise winner William Vickrey’s advice could have made you an extra 5.000 dollars!! This insight has been a major contribution of auction theory. Precisely because it is somewhat counterintuitive. Most people expect that the first price auction is more profitable, but because buyers can learn about the winners curse, they can adapt their behaviour, making it a not the best choice. That is economics at its finest!
And because it was William Vickrey that first described and studies the second price auctions, they have since also become known as Vickrey auctions and hence it makes sense that Vickrey won the Nobel prise in economic sciences for this work in 1996.
Why are non-Vickrey auctions still used?
However, as you might know, Dutch auctions, first price auctions and all of the above formats still exist, even if the second price and English auctions should be superior in theory. Now there must be some practical reasons for this. For example, our house price sale with a second auction is only likely to be superior if the bidders are experienced. However, since people don’t buy houses all that often, it could still be a good strategy to sell your house using a first-price sealed auction. What do you think? Let me know what type of auction you would use to sell your house and why, in the comments.
So, now we know that auction theory is the field that studies how people act in auctions and researches the properties of various auction markets. We also know that the 1996 Nobel prize in economic sciences was awarded to William Vickrey for showing that the Vickrey auction in many cases leads to a superior outcome for both buyers –who can bid without fear of the winners curse– and sellers who are likely to get a better price as a result.
What is next?
Now, what was next for auction theory after winning the first Nobel prize? With the rising popularity of auctions used by governments for selling of assets, economists ran into a problem when trying to sell multiple objects at once, especially those that were related to each other.
The most famous example are licenses for radio frequencies, which are very valuable if you have the right geographical combination of them, but almost worthless if you have just a few. After all, only if you have national coverage, you can run an effective telecommunications company.
And, because the right combination of frequencies differed for each phone company, it was not possible to just auction of all of them at once. So, a Vickrey auction wouldn’t work here, it would have either meant selling all frequencies at once which was very inefficient, or it would have meant selling them all separately, fetching a very low price for the government and meaning that a profitable second-hand market would likely emerge.