In 1991 ALVIN ROTH, who was to receive the Nobel Prize in Economics in 2012, was asked to speculate on how the discipline might change over the next century. “In the long run,” he wrote, “the real test of our success will be not just how well we understand the general principles that govern economic interactions, but how well we can apply that knowledge to practical issues of microeconomic engineering.” ”Mr. Roth has done his part to move the field in this direction: Among other things, he helped develop market mechanisms to reconcile sick patients with kidney donors. The Swedish Riksbank, which awards the official Economics Prize in memory of Alfred Nobel, seems to agree. On October 12th, Paul Milgrom and Robert Wilson, both from Stanford University, received this year’s award for their work on auction theory and design. Your work embodies business as engineering.
Auctions are an ancient mechanism for selling valuable goods, from fine arts to a fisherman’s catch to government bonds. In the past, some forms of auction were predominant. In an English auction, bids are placed in ascending order until there is a single winner. For the Dutch variety, a high opening price is set and slowly reduced until a bidder is found. In the 1960s, William Vickrey, who shared the Nobel Prize in 1996, developed what is known as the auction theory. He applied game theory to evaluate bidders’ optimal strategies and examined the revenue and efficiency characteristics of various auction formats. However, Vickrey focused on a relatively narrow series of cases where each bidder’s assessment of the goods sold was not related to that of all other bidders. In practice, however, it often depends on the ratings of other bidders or the seller what a person considers the value of an auctioned item to be, as they may have access to private information about its value, the evidence of which will be disclosed during the course of the auction.
In the 1960s and 1970s, Mr. Wilson began to work out how to analyze these other scenarios. He first looked at cases in which the item to be sold has an uncertain common value – for example a property with oil underneath. Different participants may have different information about the exact value (e.g. the amount of oil). In such cases, the winner will often find that the information others had about the common value led them to place lower value on the auctioned item. This can mean that the winner overestimated their worth and paid too much, a phenomenon known as the winner’s curse.
Mr Wilson’s work in this direction laid the groundwork for analyzing even more complicated scenarios that take into account both the bidders’ unique private valuations and the shared value of an item. For example, the value of an oil field can depend on both the amount of oil in the ground and the cost-effectiveness of the extraction technologies used by various bidders. Mr. Milgrom (whose doctoral thesis was supervised by Mr. Wilson) took the lead in investigating these types of cases and learned a number of important lessons from his analyzes. Auction structures that receive more private information from bidders (e.g., English auctions where each participant can observe who is bidding what and who is failing) reduce the winner’s curse problem compared to formats in which very little private information is revealed will. In some cases, it may also be to the seller’s advantage to provide bidders with more information about the item for sale.
Similar to Mr. Roth, Messrs. Milgrom and Wilson finally put the knowledge gained from their theoretical work into practice. Before the early 1990s, the American government allocated parts of the radio spectrum in an unwieldy manner: either through a so-called “beauty contest”, in which bidders essentially explained why they earned a bit more spectrum than others, or through lottery. In 1993, Congress allowed the Federal Communications Commission to allocate the spectrum through an auction instead. However, given the complexity, it was not clear how an auction could work. Different bidders from different industries had very different views of how spectrum discs could be used, and the value of a spectrum often depended critically on which other discs an owner also controlled. The winners worked with another economist, Preston McAfee, who is now at Google, to invent an entirely new format known as the Simultaneous Multiple Round Auction (SMRA). When it was first used in 1994, this format raised $ 617 million for an American government that had previously made almost nothing from the distribution of frequency rights.
Today, SMRA-style auctions are routinely used in many countries and in contexts other than the sale of frequencies – for example in the distribution of rights to natural resources or the sale of electricity. Practical problems such as frequency distribution have continued to motivate the research of the award winners and have led to the development of further specialized auction formats. Mr. Milgrom and Mr. Wilson became the epitome of the economist as engineer: applying theory to develop functional solutions to such problems.
As a result, researchers are more caught up in real-world problems than the typical awardee. Mr. Milgrom advised telecommunications companies Time Warner and Comcast on their participation in radio frequency auctions in 2006; The work helped its clients save more than $ 1 billion. In 2009 he co-founded Auctionomics, a company that provides advisory services for those who want to operate and bid at auctions.
It’s a different kind of job than what many aspiring academics imagine. But if this isn’t incentive enough for young scientists to think about returning to also put on an engineering cap, the Riksbank’s admiration could well be. This year’s award is the third since 2007, with which the “mechanism design” or the application of economic principles to the design of markets to solve real problems is recognized.