AUCTION THEORY

 Auction theory is a branch of economics that deals with, as the name suggests, auctions.

Auctions are widely used and also the most efficient mechanism to allocate scarce resources. 

It deals with the various ways in which auctions can be designed to improve seller revenues, increase benefits to consumers 

When potential buyers compete to purchase goods in an auction, it helps sellers discover those buyers who value the goods the most.

Selling goods to the highest bidder also helps the seller maximise his or her revenues. So, both buyers and sellers benefit from auctions

More sophisticated and explicit auction mechanisms are used in the allocation of capital goods such as spectrum and minerals

The most common criticism is that auctions can lead buyers to overpay for resources whose value is uncertain to them. This criticism, known as the ‘winner’s curse’. A study showed how buyers who overpaid for U.S. oil leases in the 1970s earned low returns.

No one auction design fits all types of commodities or seller,because the purpose of an auction also differs with the commodity and the entity conducting the auction.

Your bidding behaviour is likely to differ if the rules stipulate open bids as against closed/sealed bids. The same applies to single bids versus multiple bids, or whether bids are made one after another

The second variable is the commodity or service being put up for auction.

In most auctions, bidders allocate both “common” as well as “private” values to the object being auctioned and this affects their eventual bids.

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

Milgrom formulated a more general theory of auctions that not only allows common values but also private values that vary from bidder to bidder. 

Dr. Robert Wilson found that rational bidders may decide to underpay for resources in order to avoid the ‘winner’s curse’, and argued that sellers can get better bids for their goods if they share more information about it with potential buyers.

According to Dr. Milgrom added that individual bidders may still submit vastly different bids due to their unique circumstances. 

The economists working on auction theory believed that all auctions are the same when it comes to the revenues that they managed to bring in for sellers. The auction format, did not matter. This is known as the ‘revenue equivalence theorem’ .

Dr. Milgrom showed that the auction format can actually have a huge impact on the revenues earned by sellers.

The most famous case of an auction gone wrong for the seller was the spectrum auction in New Zealand in 1990.

Dr. Milgrom showed how Dutch auctions, in which the auctioneer lowers the price of the product until a buyer bids for it, can help sellers earn more revenues than English auctions.  

In the case of English auctions, the price rises based on higher bids submitted by competing buyers. 

As soon as some of the bidders drop out of the auction as the price rises, the remaining bidders become more cautious about bidding higher prices.

The combinatorial auctions designed by the duo, for instance, have been used to sell complex goods such as spectrum as bundles, instead of as individual units.

Earlier, governments sold spectrum rights on the basis of bundles. This led to private speculators earning billions in the secondary market by reselling spectrum, while the government was starved of revenues that it could have easily earned with better auction design.

The contributions of Dr. Milgrom and Dr. Wilson have helped governments and private companies design their auctions better. 

This has, helped in the better allocation of scarce resources and offered more incentives for sellers to produce complex goods.

It is commonly believed that while enthusiastic bidding may lower the returns earned by companies, it will not necessarily lead to higher prices for consumers. 

This is because in any competitive market, pricing of consumer goods is based on what the market will bear, rather than on sunk costs.