Expained: The economics of Auction Theory

News: Royal Swedish Academy of Sciences has awarded the 2020 Nobel Prize for Economics — to Paul R Milgrom and Robert B Wilson for their work on auction theory and new auction formats.

Facts:

• Auction Theory: It is an applied branch of economics which deals with how people act in auction markets and researches the properties of auction markets.
• Factors: The outcome of an auction (or procurement) depends on three factors: a) Auction’s rules or format b) Highest bid and c) Uncertainty.

What did the two Nobel Prize winners do?

• Robert Wilson: He 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.For example, the future value of radio frequencies or the volume of minerals in a particular area.
• Winner’s Curse: Wilson also explained what the “winner’s curse” in an auction is and how it affects bidding.

• As shown in the illustration, it is possible to overbid — $50 when the real value is closer to $25. In doing so, one wins the auction but loses out in reality.
  • Hence, the winner’s curse explains 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 R.Milgrom: He 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.