The professors who shaped the world of auctions

The Nobel Prize in economics has been awarded to Americans Paul Milgrom and Robert Wilson, whose work in the field of auctions genuinely shaped the way private sector entities bid for natural resources from governments and regulators. This includes things like radio frequencies and oil mining rights.

Auctions affect you directly in more ways than you realise. There’s the obvious type of auction, where you physically or virtually attend an auction and compete with other bidders for the winning bid on an item which might range from a Persian carpet through to a classic car.

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However, you’re also attending an auction whenever you book a plane ticket. In countries with more than one electricity provider (we can only dream here in South Africa), consumer electricity prices can take the form of an auction.

Do you trade shares? That’s also a type of auction.

Do you ever search anything on Google? Duh, of course you do. The ads down the side are based on an auction for that space by advertisers.

Auctions create a market by bringing buyers and sellers together

Online businesses in the auction space have flourished, as websites like eBay attract bidders and sellers seeking a concept known as “price discovery” which can only happen in a “liquid” market.

A liquid market is one where there are enough buyers and sellers to enable deals to take place without the deal price deviating materially from the actual value of the asset. This can be measured by the extent of the bid-offer spread, the difference between the highest bid from a buyer and the lowest offer by a seller.

An illiquid market may be due to lack of demand (e.g. for a high mileage unpopular car) or lack of supply (an extremely rare and collectible item). In the first example, the seller takes the pain. In the second example, the buyer must pay up to convince the seller to part with the asset.

Price discovery is the journey of buyers and sellers finding an acceptable price. The same principle applies on the stock market.

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Milgrom and Wilson made a difference to governments and regulators

The work of these two Stanford professors isn’t new. They’ve been at it since the 1990s, creating auction formats to sell many interrelated items at the same time. American regulators adopted the method in 1994 in the sale of radio frequencies.

Their trick is in a so-called “common value” auction.

This is different to a “private value” auction in which participants are likely to ascribe different values to the goods in question. Collectible items or even experiences would be great examples here. The value I might ascribe to a particular car could be totally different to yours, based on a variety of reasons like nostalgia and a long-standing goal of owning such a machine.

In a common value auction, the value of the item would be the same for all bidders, but the bidders have private information about the item’s value. For example, if a jar of coins is being auctioned, the jar would be worth exactly the same to whoever the winner is (there’s no nostalgia in a jar of coins). However, each bidder has different information about how many coins might be in the jar, which drives different bids.

The common value auction is important to governments and regulators because the auctioning of natural resources or other rights would follow this format. Stanford University said that the work of these economists had been used worldwide to allocate over $100bn in licences.

Wilson showed that bidders tend to bid below their own best estimate of the common value, for fear of “winner’s curse” i.e. over-paying. We do this all the time when we make offers on houses, cars or anything else with an uncertain prize.

If you would probably be happy paying R10 for something, that’s never your first offer, is it?

Milgrom complemented Wilson’s work with theories around differences in perceived value from bidder to bidder. As the view of one bidder is revealed to the others, their own views may be adjusted.

In case you’re wondering, the professors will share the prize of over $1.1m from Sweden’s central bank. That should pay for a few items on auction.

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