The opening match of the Indian Premier League 2020 was viewed by over 200 million people. A record-breaking viewership figure for the opening-day of a sports event in any country. This shows the buzz among viewers for this annually conducted India-based event.
What makes the show more breathtaking is the custom of the auction of players that takes place months prior to the final episode. Cricket admirers would also be aware of the most tragic bids of cricket history. Recall Tymal Mills, one of the players auctioned, was one of the most expensive purchases of season 10. Consequently, he struggled to find a purchaser in the following season because of his disappointing performance in the former season.
So why did the team pay an exorbitantly high sum of ₹120 million for such a player? What could be the reason behind the faulty valuation of Tymal Mills? The truth is that such glitches and miscalculations in auctions are not uncommon as the modern form of auctions is not just restricted to the disposal of a bankrupt’s property. It is a lot more than that. Auctioning telecom spectrums, oil wells, airport landing slots - it is indeed a mind boggling process. And a solution to such a process fetched the Nobel Prize 2020 for economics to Paul R Milgrom and Robert B Wilson. These researchers tried to evaluate the outcomes of different rules of bidding and final prices and devised a framework “for improvements to auction theory and invention of new auction formats.”
The story dates back to the times when the telecom spectrum was sold to companies in the form of beauty contests. Basically, the one with the best plan was the winner. However, it was subject to lobbying. Approaches like political markets and lotteries were also adopted though both of these approaches were biased and led to unjustified distribution. As a resort, in 1994, the laureates introduced ‘simultaneous multiple round auctions’ for radio spectrum sale. This arrangement helped governments to sell the commodity rights at a competitive price - a price not too trivial which could result in losses and not too high. It ultimately helped the sellers find the buyer who values his product most. This format initially adopted by the USA’s Federal Communications Commission (FCC) is now used throughout the world for the allocation of natural resources.
Auction theory sounds simple considering that the buyer’s motive is to be able to purchase something at the lowest possible price. Economists also try their hands at game theory to find out all the predictions that could be made by bidders before quoting a price. However, in real life auctions, this prognosis won’t be a smooth ride. As bidders with little information available about the product struggle to find out its worth. At the same time, sellers face problems executing the sale of a bunch of items at the same time. They have to protect the auction from purchasers who might collaborate amongst themselves behind the scenes hence hampering the dignity of the auction. The auction theory of these Stanford University-affiliated economists aided in implementing the sale of complex goods. Their thesis is based on the following three factors:
- They explained how rules of auction affect the behaviour of bidders and revenues brought in for sellers hence defying the ‘revenue equivalence theorem’. Are the bids open or closed? How many times can a participant bid? What amount shall the winner be liable to pay? All such statutes cause changes in the bidders’ attitude. The most suitable example of such a situation was quoted in a case study by The Hindu which narrated a spectrum auction of New Zealand which took place in 1990. The auction was a Vickrey auction. Here, the winner was liable to pay the second-highest bid. Due to this, a company that actually bid NZ$100,000 ultimately ended up paying just NZ$6. Hence a difference in guidelines brought a major transformation in the amount the seller would have earned if the rules were slightly different.
- The commodity or service that is being put to sale. The circumstances of a painting being auctioned shall enormously vary from telecom auctions.
- What are the uncertainties involved in the sale? What is the information available to a bidder about the product? A bidder is aware of the royal history of a mansion might view it differently from one unaware of it.
Wilson, according to the prize committee devised that the auction of objects with a common value which is uncertain earlier becomes common for everyone at the end and that winners should bid below the common value of a product to eschew the winner’s curse. For a more extensive understanding let’s find out what is this common value, private value, and the winner’s curse.
Winner’s curse refers to a situation when the intrinsic value of a product is lower than its estimated value. This is a phenomenon that usually arises when bidders have no way of evaluating the exact intrinsic value of a product and offer a price as per their own assessment of the object. As happened in the case of Tymal Mills stated above - the team overestimated the performance of this player ending up winning the bid but losing the game. The winner is usually the one with the most optimistic estimation of the product while he may later realise that valuation by him was way higher in comparison to other bidders. This paradox was quoted by the 2017 Economics Nobel prize winner, Richard Thaler in Misbehaving: The making of behavioural economics as “When many bidders compete for the same object, the winner of the auction is often the bidder who most overvalues the product being sold”. This phenomenon even poses a question to the hypothesis of efficient markets. If the markets would have been efficient then there wouldn’t be such variation in the valuation by different bidders as all shall possess symmetric information.
Another deciding factor for the price is the private value of the commodity. It is an individual’s outlook towards a product based on the personal information he possesses. For instance, in the auction of a painting, the private value of that art shall be the pleasure that the bidder is seeking from it for his own sake. However, when he would like to sell that painting in the future then what shall matter to him is the common value which is based on what others think will be the possible price. It is due to the private value of an object that bidders might have massive variations in their bids depending on their own circumstances. For instance, a company with an ability to sell oil at higher prices or process it at a lower price might be ready to bid higher for crude oil.
Considering this, Wilson studied the buyers who overpaid for US oil leases in the 1970's and earned lower returns due to the winner’s curse. He argued that the most rational approach is to place a bid below the perceived common value of resources. Milgrom nonetheless focused on a more general theory of auction and analysed different bidding strategies in a plethora of auction formats and concluded that it shall be the most profitable deal for the seller when they share more information with potential buyers.
Hence, these laureates have made a major contribution to society by devising a theory that has practical engineering applications. This new auction format is a more sorted approach to sell complex goods and is a well-designed system for both private and public sellers to design their auctions proficiently. With this theory, the researchers advocate that like physics and chemistry, economic theories can also create useful technologies for both companies and the government. This even justifies how economists who earlier only acted as advisors to government now play an indispensable role in corporate companies too.
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