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Fair market value

While auctions are a useful method for price discovery, they should go beyond material gains to ensure the welfare of the disadvantaged

Fair market value

We don't usually realise it, but auctions, as the prize committee that adjudicated this year's Nobel Memorial Prize in Economic Sciences recorded in its statement, are everywhere and affect our everyday lives. Internet ads, cricket players for Indian Premier League (IPL) teams, the spectrum for mobile phones, allocation of landing slots to airplanes at airports - just about everything gets priced through auctions. In fact, auctions have come to be a common mode of carrying out transactions in the modern economy.

Suitably, this year's winners of the Nobel in Economics are Stanford University professors Paul Milgrom and Robert Wilson. The two American economists are being recognised for improving our understanding of auctions in theory and in practice and for inventing new formats for conducting auctions. Milgrom and Wilson are famous for having designed the auctions that were used by the US government in 1994 for selling radio spectrum licences to wireless telephone companies (for details, see here.)

The Federal Communications Commission (FCC) had estimated at the onset that the airwave spectrum being auctioned could fetch about $10 billion. The expectation was received with a great deal of scepticism by the telecommunications industry players planning to bid for the licences on offer. After all, the US government had no previous experience of selling something as valuable. Before this, spectrum was just given away, including by a system of lotteries, to just about anyone applying. And so, a bunch of enterprising dentists had famously managed to bag a licence to run cellular phones, which they then palmed off to Southwestern Bell for a neat $41 million.

Not before long, in 1993, the FCC decided to invite proposals for airwaves auction design, creating overnight a market for the expertise of auction theorists and game theorists. Although auction theory, a branch of game theory, was developed back in the 1970s and 1980s, much of the design of the mathematical models of the auctions by the FCC came from Milgrom and Wilson and their colleague Preston McAfee of the University of Texas, Austin. By the end of the sales, the auctions had helped the FCC raise more than $120 billion. After this resounding success, the auctions designed by these economists have been adapted and used by governments around the world for selling, among other things, telecom spectrum (including in India), natural gas and electricity to the highest bidders. The amounts successful bidders pay in these auctions naturally decide how they price the services that they then offer to consumers, which is what makes their design rather interesting.

Despite doing well on revenue accrual, the 1994 FCC auction could not deliver on the public-policy goal of diversification of ownership. In subsequent rounds, therefore, the FCC reserved blocks for small entrepreneurs and firms owned by women and people from minority identities. Bidders in these special categories were also provided some concessions. For instance, credits, wherein if they bid, say, $80 in a round, it was taken to be a bid for $100. Their deposit require- ments were also much lower than other non-special category bidders. Bidders were provided a month's time to submit 10 per cent of their bid sum, with the remaining amount to be paid seven years later. A nominal interest was charged for this loan, creating a common economics problem of moral hazard. If seven years later, the auctioned item happened to lose value, becoming worth less than 90 per cent of the bid price, then the winning bidders' rational response was to default, since the loss was limited to the down payment of only 10 per cent. Indeed, a majority of the winners of the licences declared bankruptcy and wound up or sold their business to a larger company. The design defect led to further corrections in the auction formats subsequently.

The complexity of designing auctions, as also preparing winning bids in an auction, comes from the various unknowns involved: how differently would the potential bidders put values on the item being auctioned? Would they assess with some degree of accuracy how their competitors are likely to bid? How may the conductors of auctions ensure a fair market and preclude the possibility of collusion among bidders? Auction theorists have succeeded in formulating neat and precise algorithms and mathematical models factoring in bidders' behaviours. In any auction, the bidders' goal is to buy the item on sale paying the lowest price possible while ensuring this price does not exceed the intrinsic value or the true worth of the item on auction. Items on auction can be of two types. One, where their value is uncertain before the start of the auction, but by its end, all bidders' value of it is the same. Wilson developed the theory for auctions of this type of objects with a common value. Milgrom built on it to give a general approach where every bidder has a distinct private value for the item on auction.

More recently, the two economists have been focused on finding the best strategies for accelerating the deployment of fifth-generation, or '5G', wireless technology. The duo, after the prize was announced by the Royal Swedish Academy of Sciences, has announced how they are applying their career's work on auction design to find solutions for the problems posed by the COVID challenge. These include the optimal allocations of medical supplies that are scarce: personal protective equipment (PPE) and respirators. In the early stages of the outbreak in the US, the states were competing against each other, bidding up the prices of these essentials.

One reason auctions are extremely valuable is that they remind us of the important role of markets in the modern economy. In well-functioning markets, prices provide information about how much sellers and buyers value an item on sale. A Rs 10,000 cell phone is normally not likely to be as well-made as a Rs 40,000 one. Until the time something has a market, its material value is opaque and indeterminate. At the same time, material value is not everything. As the FCC auctions showed, modern societies may want to go beyond material gains to neutralise historic disadvantages faced by certain classes of people, such as women, by offering special concessions.

Puja Mehra is a Delhi-based journalist and the author of The Lost Decade 2008-18: How the India Growth Story Devolved into Growth Without a Story.