The story behind the 2020 Nobel Prize in economics
The Nobel Prize for Economics this year was shared by two Americans, Paul Milgrom and Robert Wilson of Stanford University. In the announcement live-streamed to a global audience on October 12, the Royal Swedish Academy of Sciences said Paul Milgrom and Robert Wilson are being honoured "for improvements to auction theory and inventions of new auction formats." The pioneering work of these economists in auction theory has helped develop better real-world transactions in disciplines as diverse as home-buying and government sales of radio spectrum. "Their discoveries have benefited sellers, buyers and taxpayers around the world," the Prize Committee said.
In economics, resource allocation is a core issue. Since the days of Adam Smith, many generations of economists have touted the virtue of free markets, which Smith viewed as "invisible hands", and espoused the outcomes, particularly the price and quantity that emerged from a freely functioning competitive market.
However, at the beginning of the last century, Keynes and later many other economists including George Akerlof, Michael Spence, and Joseph E Stiglitz, argued that free market is just an illusion. In economics, the concept of "perfect competition" (PC) is based on the assumption of many buyers and sellers, perfect information, and absence of collusion among the economic agents. Wilson and Milgrom bypassed the PC framework and developed "market design" and "auction theory" based on some fundamental principles laid down by John Von Neumann and Oskar Morgenstern in their ground-breaking treatise, "Theory of Games and Economic Behavior".
Wilson has been breeding Nobel Laureates at Stanford and three of his students won the award for their work on game theory and market design including Alvin Roth (2012), Bengt Robert Holmström (2016), and Milgrom (2020).
Auctions have been ancient tools and economists adapted the concepts of game theory to develop the behaviour of buyers and sellers in different auction settings. In an interview immediately after the prize was announced, Milgrom recounted a pivotal moment in 1993 that catapulted auctions to the mainstream. The US Congress authorised the introduction of the auction of radio-spectrums, and designers worked to create "marketplaces in which the messages are bids, and the auction rules determine the form that bids take, how they are communicated, and how they determine the payments and allocation of the items being auctioned," in the words of Alvin Roth, a 2012 Nobel winner.
In a basic auction, there is a product (or products) with multiple buyers offering their bids. The complications arise when we introduce collusion between the buyers or cooperative behaviour, asymmetric information, and nonbinding bids. The important contribution that Wilson and Milgrom made is to create auctions for various items and to design them so that not only is the price (or revenue) for the seller maximised but also the highest bidder does not go bankrupt.
For illustration, let me take an example from Harvard Business School's student blog. Imagine that at the beginning of a class, the professor produces a jar full of coins and announces that he is auctioning it off. Students can write down a bid, he explains, and the highest bidder wins the contents of the jar in exchange for his or her bid. After everyone has written down their bids, the professor polls the class to find out how they bid. Bob turns out to be the high bidder at USD 45.
"Congratulations, Bob, you've just won all the coins in the jar!" the professor says. "How do you feel?"
"Lousy," says Bob, before even hearing how much money the jar contains.
Why did Bob feel remorse even though he won the bid? The reason is that he did not know the real value of the jar of coins. After the auction was over, when the class counted the coins, it turned out to have only USD 22 of pennies. The class was bidding on the coins with "incomplete information". In an auction with incomplete information, bidders might lose touch with the "intrinsic value" of the item, and this might make the bidders overestimate the value of the item and lead to inefficiencies. In the example of the lottery above, Bob who outbid others and won the bidding is suffering from a phenomenon known as the "winner's curse".
"The winner's curse is a tendency for the winning bid in an auction to exceed the intrinsic value or true worth of an item." The reasons why the value of S)0 where S= (winning bid minus intrinsic value) are incomplete information, bidder's emotions, or a variety of other subjective factors.
Before Milgrom and Wilson started working on the problem in the early 1990s, the United States Federal Communications Commission (FCC) allocated radio frequencies by inviting applications and then doing lotteries. "As mobile phone use expanded, the processes became unreasonably costly to the government and unsatisfactory to the mobile service providers," writes Taylor Kubota of Stanford University.
Smartphones have put marketplaces in our pockets, and as computerised marketplaces become ever more ubiquitous, we will also generate data trails that will continue to extend the reach of markets, socially and personally. "We will learn more about privacy and fairness, and there will be new opportunities for which new market mechanisms, rules, customs, and regulations will have to be designed," said Roth and Wilson in a joint paper last year.
Wilson and Milgrom invented a new auction format, called Simultaneous Multiple Round Auction (SMRA). In these auctions, all biddable items are offered simultaneously and bidders can bid on any portion of the items. The bids start low, in order to avoid the winner's curse, and the auction ends when no bids are placed in a round. The first SMRA auction in 1994 sold 10 licenses over 47 rounds, fetching USD 617 million. Milgrom helped design a new format, known as the "incentive auction" which resulted in the sale of 70 MHz of wireless internet licenses for USD 19.8 billion in 2016. Nowadays, auctions are commonplace in electricity, labour markets, kidney transplants, and other matching markets, including doctors' placements known as the National Resident Matching Program (NRMP) in the USA.
On Stanford University's website, Robert Wilson professes his research interests as principally game theory and its applications to business and economics. He has been a major contributor to auction designs and competitive bidding strategies in the oil, communication, and power industries, and to the design of innovative pricing schemes.
The Nobel Committee was effusive in its admiration for auctions. "The new auction formats are a beautiful example of how basic research can subsequently generate inventions that benefit society. The unusual feature of this example is that the same people developed the theory and the practical applications. The Laureates' ground-breaking research about auctions has thus been of great benefit, for buyers, sellers and society as a whole."
Unfortunately, neither of them will be able to travel to Stockholm on December 10 to receive the Award Ceremony in person but will participate virtually.
Incidentally, for Milgrom it was a very sweet and memorable moment when Robert Wilson, his PhD supervisor at Stanford and now neighbour in Palo Alto, CA walked over to his house with his wife in the early hours of October 12 to convey the good news to him. Wilson rang the doorbell. "Paul, it's Bob Wilson. You've won the Nobel Prize. And so they're trying to reach you, but they cannot. They don't seem to have a number for you," Wilson said over the video doorbell.
Milgrom received a call from Nobel Media 20 minutes after he heard the news. In a conversation with Adam Smith, Chief Scientific Officer of Nobel Media, Milgrom was asked a question that is on everyone's mind: "How does the work you've done together on auctions help policy makers improve individuals' economic stability these days?"
He responded that his work on resource-allocation problems and how to create markets that allocate goods efficiently will be relevant in beating the pandemic and mitigating climate change. "The biggest challenges today are of course the medical challenges, the vaccine development, the way we will address the shortages that exist and taking care of displaced people that has resulted from the pandemic." Efficient method design will be invaluable to solve these resource-allocation problems as well as the other big challenges of the date including efficient allocation of environmental resources.
The story behind the 2020 Nobel Prize in economics