Economic theory is often abused in practical policy-making. There is frequentlyexcessive focus on sophisticated theory at the expense of elementary theory; toomuch economic knowledge can sometimes be a dangerous thing. Too littleattention is paid to the wider economic context, and to the dangers posed bypolitical pressures. Superficially trivial distinctions between policy proposalsmay be economically significant, while economically irrelevant distinctions maybe politically important. I illustrate with some disastrous government auctions,but also show the value of economic theory.
For half a century or more after the publication of his Principles (1890), it wasroutinely asserted of economic ideas that ‘‘they’re all in Marshall’’. Of course,that is no longer true of the theory itself. But Marshall was also very concernedwith applying economics, and when we think about how to use the theory, theexample that Marshall set still remains a valuable guide. In this chapter, there-fore, I want to use some of Marshall’s views, and my own experience inauction design, to discuss the use (and abuse) of economic theory.1
* This chapter was originally published under the title ‘‘Using and Abusing Economic Theory’’,
in the Journal of the European Economic Association, 2003, 1, 272–300. (It is also reprinted inAdvances in Economics and Econometrics: Theory and Applications, S. Hurn (ed.), forthcoming.)It was improved by an enormous number of helpful comments from Tony Atkinson, SushilBikhchandani, Erik Eyster, Nils-Henrik von der Fehr, Tim Harford, Michael Landsberger, KristenMertz, Meg Meyer, Paul Milgrom, David Myatt, Marco Pagnozzi, Rob Porter, Kevin Roberts,Mike Rothschild, Peter Temin, Chris Wallace, Mike Waterson, and many others.
1 This is the text of the 2002 Alfred Marshall Lecture of the European Economic Association,
given at its Annual Congress, in Venice.
I gave a similar lecture at the 2002 Colin Clark Lecture of the Econometric Society, presented
to its Annual Australasian Meeting. Like Marshall, Clark was very involved in practical economicpolicy making. He stressed the importance of quantification of empirical facts which, I arguebelow, is often underemphasized by modern economic theorists.
Similar material also formed the core of the biennial 2002 Lim Tay Boh Lecture in Singapore.
Lim was another very distinguished economist (and Vice-Chancellor of the National University ofSingapore), who also made significant contributions to policy, as an advisor to the SingaporeGovernment.
Finally, some of these ideas were presented in the Keynote Address to the 2002 Portuguese
Economic Association’s 2002 meetings.
I am very grateful to all those audiences for helpful comments.
Although the most elegant mathematical theory is often the most influential,
it may not be the most useful for practical problems. Marshall (1906) famouslystated that ‘‘a good mathematical theorem dealing with economic hypotheses[is] very unlikely to be good economics’’, and continued by asserting the rules‘‘(1) Translate [mathematics] into English; (2) then illustrate by examples thatare important in real life; (3) burn the mathematics; (4) if you can’t succeed in2, burn 1’’! Certainly this view now seems extreme, but it is salutary to bereminded that good mathematics need not necessarily be good economics. Toslightly update Marshall’s rules, if we cannot (1) offer credible intuition and(2) supply empirical (or perhaps case-study or experimental) evidence, weshould (4) be cautious about applying the theory in practice.2
Furthermore, when economics is applied to policy, proposals need to be
robust to the political context in which they are intended to operate. Too manyeconomists excuse their practical failure by saying ‘‘the politicians (or bureau-crats) didn’t do exactly what I recommended’’. Just as medical practitionersmust allow for the fact that their patients may not take all the pills theyprescribe, or follow all the advice they are given, so economics practitionersneed to foresee political and administrative pressures and make their plansrobust to changes that politicians, bureaucrats, and lobbyists are likely toimpose. And in framing proposals, economists must recognize that policiesthat seem identical, or almost identical, to them may seem very different topoliticians, and vice versa.
Some academics also need to widen the scope of their analyses beyond the
confines of their models which, while elegant, are often short on real-worlddetail. Marshall always emphasized the importance of a deep ‘‘historicalknowledge of any area being investigated and referred again and again tothe complexity of economic problems and the naivety of simple hypotheses.’’3Employing ‘‘know it all’’ consultants with narrowly focused theories insteadof experienced people with a good knowledge of the wider context can some-times lead to disaster.
One might think these lessons scarcely needed stating—and Marshall
certainly understood them very well—but the sorry history of ‘‘expert’’advice in some recent auctions shows that they bear repetition. Soalthough the lessons are general ones, I will illustrate them using auctionsand auction theory: Auction theory is often held up as a triumph of theapplication of economic theory to economic practice, but it has not, intruth, been an unalloyed success. For example, while the European andAsian 3G spectrum auctions famously raised over 100 billion euros in
2 I mean cautious about the theory. Not dismissive of it. And (3) seems a self-evident mistake, if
only because of the need for efficient communication among, and education of, economists, letalone the possibilities for further useful development of the mathematics.
3 Sills (1968, p. 28). An attractively written appreciation of Marshall and his work is in Keynes
U S I N G A N D A B U S I N G A U C T I O N T H E O R Y
total revenues, Hong Kong’s, Austria’s, the Netherlands’, and Switzer-land’s auctions, among others, were catastrophically badly run yieldingonly a quarter or less of the per capita revenues earned elsewhere—andeconomic theorists deserve some of the blame.4,5 Hong Kong’s auction,for example, was superficially well designed, but not robust to relativelyslight political interference that should perhaps have been anticipated. Several countries’ academic advisors failed to recognize the importanceof the interaction between different countries’ auction processes, andbidders advised by experts in auction theory who ignored (or were ignor-ant of) their clients’ histories pursued strategies that cost them billions ofeuros. Many of these failures could have been avoided if the lessons hadbeen learnt to: pay more attention to elementary theory, to the widercontext of the auctions, and to political pressures—and pay less attentionto sophisticated mathematical theory.6
Of course, mathematical theory, even when it has no direct practical
application, is not merely beautiful. It can clarify the central features of aproblem, provide useful benchmarks and starting points for analysis and—especially—show the deep relationships between problems that are super-ficially unconnected. Thus, for example, the sophisticated tools of auctiontheory that have sometimes been abused in practical contexts turn out tohave valuable applications to problems that, at first blush, do not look likeauctions.
Section 4.2 briefly discusses what is often taken to be the ‘‘standard
auction theory’’, before discussing its real relevance. Sections 4.3–4.5 illus-trate its abuse using examples from the Asian and European 3G auctions,and discuss the broader lessons that can be drawn from these misapplica-tions. Section 4.3 is in large part based on Klemperer (2000b) and chapters
4 We take the governments’ desire for high revenue as given, and ask how well the auctions
met this objective. While an efficient allocation of licenses was most governments’ first priority,there is no clear evidence of any differences between the efficiencies of different countries’allocations, so revenues were seen as the measure of success. Section 6.2 argues that govern-ments were correct to make revenue a priority because of the substantial deadweight losses ofraising government funds by alternative means, and because the revenues were one-time sunkcosts for firms so should be expected to have only limited effects on firms’ subsequent invest-ment and pricing behavior.)
5 The six European auctions in year 2000 yielded 100 (Austria), 615 (Germany), 240 (Italy), 170
(Netherlands), 20 (Switzerland), and 650 (United Kingdom) euros per capita for very similarproperties. True, valuations fell during the year as the stockmarkets also fell, but chapter 5 detailsa variety of evidence that valuations ranged from 300 to 700 euros per capita in all of theseauctions. Chapter 5 gives a full description of all nine west European 3G auctions.
6 Another topical example of overemphasis on sophisticated theory at the expense of elementary
theory is European merger policy’s heavy focus on the ‘‘coordinated’’ effects that may be facili-tated by a merger (and about which we have learnt from repeated game theory) and, at the time ofwriting, relative lack of concern about the more straightforward ‘‘unilateral’’ effects of mergers(which can be understood using much simpler static game theory). (As a UK CompetitionCommissioner, I stress that this criticism does not apply to UK policy!)
3 and 5 where additional details can be found (and this section may beskipped by readers familiar with all that material) but the other sectionsmake different points using additional examples. Section 4.6 illustrates howthe same concepts that are abused can have surprisingly valuable uses indifferent contexts. Section 4.7 concludes.
The core result that everyone who studies auction theory learns is the remark-able Revenue Equivalence Theorem (RET).7 This tells us, subject to somereasonable-sounding conditions, that all the standard (and many non-standard)auction mechanisms are equally profitable for the seller, and that buyers arealso indifferent between all these mechanisms.
If that were all there was to it, auction design would be of no interest. But of
course the RET rests on a number of assumptions. Probably the most influen-tial piece of auction theory apart from those associated with the RET isMilgrom and Weber’s (1982a) remarkable paper—it is surely no coincidencethat this is also perhaps the most elegant piece of auction theory apart from theRET. Milgrom and Weber’s seminal analysis relaxes the assumption thatbidders have independent private information about the value of the objectfor sale, and instead assumes bidders’ private information is affiliated. This issimilar to assuming positive correlation,8 and under this assumption they showthat ordinary ascending auctions are more profitable than standard (first-price)sealed-bid auctions, in expectation.
Milgrom and Weber’s beautiful work is undoubtedly an important piece
of economic theory and it has been enormously influential.9 As a result,many economists leave graduate school ‘‘knowing’’ two things aboutauctions. First, that if bidders’ information is independent then all auctionsare equally good, and second, that if information is affiliated (which is
7 The RET is due in an early form to Vickrey (1961), and in its full glory to Myerson
(1981), Riley and Samuelson (1981), and others. A typical statement is ‘‘Assume each of agiven number of risk-neutral potential buyers has a privately known signal about the value ofan object, independently drawn from a common, strictly increasing, atomless distribution. Thenany auction mechanism in which (i) the object always goes to the buyer with the highestsignal, and (ii) any bidder with the lowest feasible signal expects zero surplus, yields the sameexpected revenue (and results in each bidder making the same expected payment as a functionof her signal).’’
See chapter 1 for further discussion of the RET.
8 Affiliation is actually a stronger assumption, but it is probably typically approximately
9 Not only is the concept of affiliation important in applications well beyond auction theory
(see section 4.6) but this paper was also critical to the development of auction theory, in thatit introduced and analyzed a general model including both private and common value compo-nents.
U S I N G A N D A B U S I N G A U C T I O N T H E O R Y
generally the plausible case) then the ascending auction maximizes theseller’s revenue.10 But is this correct?
Marshall’s (updated) tests are a good place to start. The value of empiricalevidence needs no defense, while examining the plausibility of an intuitionhelps check whether an economic model provides a useful caricature of thereal world, or misleads us by absurdly exaggerating particular features of it.11
The intuition behind the exact RET result cannot, to my knowledge, be
explained in words that are both accurate and comprehensible to lay people. Anyone with the technical skill to understand any verbal explanation wouldprobably do so by translating the words back into the mathematical argument. But it is easier to defend the weaker claim that it is ambiguous which of thetwo most common auction forms is superior: it is easy to explain that parti-cipants in a sealed-bid auction shade their bids below their values (unlike in anascending auction), but that the winner determines the price (unlike in anascending auction), so it is not hard to be convincing that there is no clearreason why either auction should be more profitable than the other. This is notquite the same as arguing that the standard auction forms are approximatelysimilarly profitable, but the approximate validity of the RET (under its keyassumptions) in fact seems consistent with the available evidence. (Somewould say that the mere fact that both the ascending auction and the sealed-bid auction are commonly observed in practice is evidence that neither isalways superior.) So the ‘‘approximate RET’’ seems a reasonable claim inpractice, and it then follows that issues assumed away by the RET’s assump-tions should be looked at to choose between the standard auction forms. Theseissues should include not just those made explicitly in the statement of thetheorem, for example, bidders are symmetric and risk-neutral; but also thosethat are implicit, for example, bidders share common priors and play non-cooperative Nash equilibrium; or semi-implicit, for example, the number andtypes of bidders are independent of the auction form.
However, as already noted, much attention has focused on just one of the
RET’s assumptions, namely independence of the bidders’ information, and thetheoretical result that if information is non-independent (affiliated) then ascend-ing auctions are more profitable than first-price sealed-bid auctions. There is novery compelling intuition for this result. The verbal explanations that are given
10 Or, to take just one very typical example from a current academic article ‘‘The one useful
thing that our single unit auction theory can tell us is that when bidders’ [signals] are affiliated …the English [i.e., ascending] auction should be expected to raise the most revenue.’’
11 Whether the intuition need be non-mathematical, or even comprehensible to lay people,
depends on the context, but we can surely have greater confidence in predicting agents’ actionswhen the agents concerned understand the logic behind them, especially when there are fewopportunities for learning.
are unconvincing and/or misleading, or worse. The most commonly given‘‘explanation’’ is that ascending auctions allow bidders to be more aggressive,because their ‘‘winner’s curses’’ are reduced,12 but this argument is plainwrong: the winner’s curse is only a feature of common-value auctions, butcommon values are neither necessary nor sufficient for the result.13
A better explanation of the theoretical result is that bidders’ profits derive
from their private information, and the auctioneer can profit by reducing thatprivate information.14 An ascending auction reveals the information of bidderswho drop out early, so partially reveals the winner’s information (if bidders’information is correlated), and uses that information to set the price (throughthe runner-up’s bid), whereas the price paid in a sealed-bid auction cannot usethat information. Since the ascending and sealed-bid auctions are revenue-equivalent absent any correlation (i.e., with independent signals), andprovided the runner-up’s bid responds to the additional information that anascending auction reveals in the appropriate way (which it does when infor-mation is affiliated), this effect makes the ascending auction the more profit-able. Of course, this argument is obviously still incomplete,15,16 and even if it
12 The ‘‘winner’s curse’’ reflects the fact that winning an auction suggests one’s opponents have
pessimistic views about the value of the prize, and bidders must take this into account by biddingmore conservatively than otherwise.
13 The result applies with affiliated private values, in which bidders’ values are unaffected by
others’ information, so there is no winner’s curse, and the result does not apply to independent-signal common-value auctions which do suffer from the winner’s curse. (Where there is a winner’scurse, the ‘‘theory’’ behind the argument is that bidders’ private information can be inferred fromthe points at which they drop out of an ascending auction, so less ‘‘bad news’’ is discovered at themoment of winning than is discovered in winning a sealed-bid auction, so bidders can bid moreaggressively in an ascending auction. But this assumes that bidders’ more aggressive bidding morethan compensates for the reduced winner’s curse in an ascending auction—in independent-signalcommon-value auctions it exactly compensates, which is why there is no net effect, as the RETproves.)
In fact, many experimental and empirical studies suggest bidders fail to fully account for
winner’s curse effects, so these effects may in practice make sealed-bid auctions more profitablethan ascending auctions!
14 Absent private information, the auctioneer would sell to the bidder with the highest expected
valuation at that expected valuation, and bidders would earn no rents. The more general result that,on average, the selling price is increased by having it depend on as much information as possibleabout the value of the good, is Milgrom and Weber’s (1982a, 2000) Linkage Principle. However,in more recent work, Perry and Reny (1999) show that the Principle applies less generally (even intheory) than was thought.
15 Revealing more information clearly need not necessarily reduce bidders’ profits (if bidders’
information is negatively correlated, the contrary is typically true), the conditions that make theascending price respond correctly to the additional information revealed are quite subtle, and nordoes the argument say anything about how affiliation affects sealed bids. Indeed there are simpleand not unnatural examples with the ‘‘wrong kind’’ of positive correlation in which the ranking ofauctions’ revenues is reversed (see Bulow and Klemperer, forthcoming), and Perry and Reny(1999) also show the trickiness of the argument by demonstrating that the result only holds forsingle-unit auctions. A more complete verbal argument for the theoretical result is given inAppendix 1.C, but it is very hard (certainly for the layman).
U S I N G A N D A B U S I N G A U C T I O N T H E O R Y
were fully convincing, it would depend on the exact RET applying—whichseems a very strong claim.
Furthermore, before relying on any theory mattering in practice, we need to
ask: what is the likely order of magnitude of the effect? In fact, numericalanalysis suggests the effects of affiliation are often tiny, even when bidderswho exactly fit the assumptions of the theory compute their bids exactly usingthe theory. Riley and Li (1997) analyze equilibrium in a natural class ofexamples and show that the revenue difference between ascending and first-price auctions is very small unless the information is very strongly affiliated:when bidders’ values are jointly normally distributed, bidders’ expected rentsare about 10 percent (20 percent) higher in a sealed-bid auction than in anascending auction even for correlation coefficients as high as 0.3 (0.5). Sothese results suggest affiliation could explain why a 3G spectrum auctionearned, for example, 640 rather than 650 euros per capita when bidders’valuations were 700 euros per capita. But the actual range was from just 20(twenty) to 650 euros per capita! Riley and Li also find that even with verystrong affiliation, other effects, such as those of asymmetry, are more impor-tant and often reverse the effects of affiliation, even taking the numbers ofbidders, non-cooperative behavior, common priors, etc., as given.17 This kindof quantitative analysis surely deserves more attention than economists oftengive it.
16 Another loose intuition is that in an ascending auction each bidder acts as if he is competing
against an opponent with the same valuation. But in a sealed-bid auction a bidder must outbidthose with lower valuations. With independent valuations, the RET applies. But if valuations areaffiliated, a lower valuation bidder has a more conservative estimate of his opponent’s valuationand therefore bids more conservatively. So a bidder in a sealed-bid auction attempting to outbidlower-valuation bidders will bid more conservatively as well. But this argument also rests on theRET applying exactly, and even so several steps are either far from compelling (e.g., the optimalbid against a more conservative opponent is not always to be more conservative), or very non-transparent.
17 An easier numerical example than Riley and Li’s assumes bidder i’s value is v ¼
which u and the ti’s are independent and uniform on ½0; 1; and i knows only vi. With two bidders,expected revenue is 14/18 in a first-price sealed-bid auction and 15/18 in an ascending auction, sobidder rents are 7/18 and 6/18 respectively (though with n bidders of whom n/2 each win a singleobject, as n ! 1 bidder rents are 42 percent higher in the sealed-bid auction).
With very extreme affiliation, an auctioneer’s profits may be more sensitive to the auction
form. Modifying the previous example so that there are two bidders who have completely diffusepriors for u, bidder rents are 50 percent higher in a first-price sealed-bid auction than in anascending auction (see Appendix 1.D), and Riley and Li’s example yields a similar result forcorrelation coefficients around 0.9 (when bidder rents are anyway small). These examples assumeprivate values. Auctioneers’ profits may also be more sensitive to auction form with commonvalues and, in the previous extreme-affiliation model with diffuse priors on u, if bidders’ signalsare vi and the true common value is u, bidders’ rents are twice as high in the sealed-bid auction asin the ascending auction. But, with common values, small asymmetries between bidders are verymuch more important than affiliation (see Klemperer, 1998; Bulow and Klemperer, 2002). More-over, we will see that other effects also seem to have been quantitatively much more important inpractice than affiliation is even in any of these theoretical examples.
Finally, all the previous discussion is in the context of single-unit auctions.
Perry and Reny (1999) show that the result about affiliation does not hold—even in theory—in multi-unit auctions.18
Given all this, it is unsurprising that there is no empirical evidence (that I
am aware of) that argues the affiliation effect is important.19,20
So there seems no strong argument to expect affiliation to matter much in
most practical applications; independence is not the assumption of the RETthat most needs relaxing.
The theory that really matters most for auction design is just the very
elementary undergraduate economics of relaxing the implicit and semi-implicit assumptions of the RET about (fixed) entry and (lack of) collusion.21The intuitions are (as Marshall says they should be) easy to explain—we willsee that it is clear that bidders are likely to understand and therefore to followthe undergraduate theory. By contrast the intuition for affiliation gives nosense of how bidders should compute their bids, and the calculations requiredto do so optimally require considerable mathematical sophistication and aresensitive to the precise assumptions bidders make about the ‘‘prior’’ distribu-tions from which their and others’ private information is drawn. Of course, thisdoes not mean agents cannot intuitively make approximately optimal deci-sions (Machlup, 1946; Friedman, 1953), and individual agents need not under-stand the intuitions behind equilibrium group outcomes. But we can be moreconfident in predicting that agents will make decisions whose logic is veryclear, especially in one-off events such as many auctions are.
Not surprisingly, practical examples of the undergraduate theory are easy to
give (as Marshall also insists). But there is no elegant theory applying to thespecific context of auctions; such theory is unnecessary since the basic point isthat the main concerns in auctions are just the same as in other economicmarkets, so much of the same theory applies (see below). Furthermore, some
18 The RET, also, only generalizes to a limited extent to multi-unit auctions. 19 For example, empirical evidence about timber sales suggests rough revenue equivalence, or
even that the sealed-bid auction raises more revenue given the number of bidders (Hansen, 1986;Mead and Schneipp, 1989; Paarsch, 1991; Rothkopf and Engelbrecht-Wiggans, 1993; Haile,1996) though information is probably affiliated. The experimental evidence (see Kagel andRoth, 1995; Levin, Kagel, and Richard, 1996) is also inconclusive about whether affiliation causesany difference between the revenues from ascending and sealed-bid auctions.
20 Like Marshall, Colin Clark (1939) emphasized the importance of quantification and real-
world facts (see note 1), writing ‘‘I have … left my former colleagues in the English Universities… with dismay at their continued preference for the theoretical … approach to economicproblems. Not one in a hundred … seems to understand [the need for] the testing of conclusionsagainst … observed facts…’’ ‘‘…The result is a vast output of literature of which, it is safe to say,scarcely a syllable will be read in fifty years’ time.’’ I think he would be pleased that an academicfrom an English University is quoting his syllables well over 50 years after he wrote them.
21 See chapter 3 and section 4.3. Risk-aversion and asymmetries (even absent entry issues) also
arguably matter more than affiliation (and usually have the opposite effect). It is striking thatMaskin and Riley’s (1984, 2000b) important papers on these topics (see also Matthews, 1983, etc.)failed to have the same broad impact as Milgrom and Weber’s work on affiliation.
U S I N G A N D A B U S I N G A U C T I O N T H E O R Y
of the key concerns are especially prominent when the assumption of symme-try is dropped, and models with asymmetries are often inelegant.
So graduate students are taught the elegant mathematics of affiliation and
whenever, and wherever, I give a seminar about auctions in practice,22 I amasked a question along the lines of ‘‘Haven’t Milgrom and Weber shown thatascending auctions raise most revenue, so why consider other alternatives?’’. This is true of seminars to academics. It is even more true of seminars to policymakers. Thus, although a little knowledge of economic theory is a good thing,too much knowledge can sometimes be a dangerous thing. Moreover, theextraordinary influence of the concept of affiliation is only the most importantexample of this. I give a further illustration, involving over-attention to someof my own work, in the next subsection. In short, a little graduate education inauction theory can often distract attention from the straightforward ‘‘under-graduate’’ issues that really matter.23
4.3 The Elementary Economic Theory that Matters
What really matters in practical auction design is robustness against collusionand attractiveness to entry—just as in ordinary industrial markets.24 Since Ihave repeatedly argued this, much of this section is drawn from Klemperer(2000b) and chapters 3 and 5 (any reader familiar with all this material maywish to skip to section 4.4).
The received theory described above takes the number of bidders as given. But the profitability of an auction depends crucially on the number ofbidders who participate, and different auctions vary enormously in their
22 I have done this in over twenty countries in five continents. 23 True, the generally accepted notion of the ‘‘received auction theory’’ is changing and so is the
auction theory that is emphasized in graduate programs. And recent auctions research has beenheavily influenced by practical problems. But it will probably remain true that the elegance of atheory will remain an important determinant of its practical influence.
24 Of course, auction theorists have not altogether ignored these issues—but the emphasis on
them has been far less. The literature on collusion includes Robinson (1985), Cramton, Gibbons,and Klemperer (1987), Graham and Marshall (1987), Milgrom (1987), Hendricks and Porter(1989), Graham, Marshall, and Richard (1990), Mailath and Zemsky (1991), McAfee and McMil-lan (1992), Menezes (1996), Weber (1997), Engelbrecht-Wiggans and Kahn (1998c), Ausubel andSchwartz (1999), Brusco and Lopomo (2002a), Hendricks, Porter, and Tan (1999) and Cramtonand Schwartz (2000). That on entry includes Matthews (1984), Engelbrecht-Wiggans (1987),McAfee and McMillan (1987c, 1988), Harstad (1990), Engelbrecht-Wiggans (1993), Levin andSmith (1994), Bulow and Klemperer (1996), Menezes and Monteiro (2000), Persico (2000b),Klemperer (1998) and Gilbert and Klemperer (2000). See also sections 1.8, 1.9 and the Afterwordto chapter 1.
attractiveness to entry; participating in an auction can be a costly exercisethat bidders will only undertake if they feel they have realistic chances ofwinning. In an ascending auction a stronger bidder can always top any bidthat a weaker bidder makes, and knowing this the weaker bidder may notenter the auction in the first place—which may then allow the strongerbidder to win at a very low price. In a first-price sealed-bid auction, bycontrast, a weaker bidder may win at a price that the stronger bidder couldhave beaten, but did not because the stronger bidder may risk trying to winat a lower price and cannot change his bid later. So more bidders may entera first-price sealed-bid auction.25
The intuition is very clear, and there is little need for sophisticated theory.
Perhaps because of this, or because the argument depends on asymmetriesbetween bidders so any theory is likely to be inelegant, theory has largelyignored the point. Vickrey’s (1961) classic paper contains an example (rele-gated to an appendix, and often overlooked) which illustrates the basic pointthat the player who actually has the lower value may win a first-price sealed-bid auction in Nash equilibrium, but that this cannot happen in an ascendingauction (with private values). But little has been said since.
In fact, some of what has been written about the issue of attracting entry
provides a further illustration of the potentially perverse impact of sophisticatedtheory. Although the point that weaker bidders are unlikely to win ascendingauctions, and may therefore not enter them, is very general, some work—includ-ing Klemperer (1998)26—has emphasized that the argument is especiallycompelling for ‘‘almost-common-value’’ auctions, and this work may have hadthe unintended side-effect of linking the entry concern to common values in somepeople’s minds;27 I have heard economists who know the latter work all too wellsay that because an auction does not involve common values, therefore there is noentry problem!28 To the extent that the almost-common values theory (which isboth of more limited application, and also assumes quite sophisticated reasoningby bidders) has distracted attention from the more general point, this is anotherexample of excessive focus on sophisticated theory at the expense of moreelementary, but more crucial, theory.
25 The point is similar to the industrial-organization point that because a Bertrand market is
more competitive than a Cournot market for any given number of firms, the Bertrand market mayattract less entry, so the Cournot market may be more competitive if the number of firms isendogenous.
26 See also Bikhchandani (1988), Bulow, Huang, and Klemperer (1999), Bulow and Klemperer
(2002), and Klemperer and Pagnozzi (forthcoming).
27 In spite of the fact that I have made the point that the argument applies more broadly in, for
example, Klemperer (1999b, 2000b). See also sections 2.3.1, 3.3, and Gilbert and Klemperer(2000).
28 Similarly others have asserted that the reason the United Kingdom planned to include a
sealed-bid component in its 3G design if only four licenses were available for sale (see below),was because the auction designers (who included me) thought the auction was almost-commonvalues—but publicly available government documents show that we did not think this was likely.
U S I N G A N D A B U S I N G A U C T I O N T H E O R Y
There is an additional important reason why a first-price sealed-bid auction
may be more attractive to entrants: bidders in a sealed-bid auction may bemuch less certain about opponents’ strategies, and the advantage of strongerplayers may therefore be less pronounced, than standard equilibrium theorypredicts. The reason is that in practice, players are not likely to share commonpriors about distributions of valuations and, even if they do, they may not playNash equilibrium strategies (i.e., a sealed-bid auction induces ‘‘strategicuncertainty’’). So even if players were in fact ex-ante symmetric (i.e., theirprivate information is drawn from identical distributions) the lower-valueplayer might win a first-price sealed-bid auction, but would never win anascending auction (in which bidders’ strategies are very straightforward andpredictable). When players are not symmetric, Nash equilibrium theorypredicts that a weaker player will sometimes beat a stronger player in asealed-bid auction, but I conjecture strategic uncertainty and the absence ofcommon priors make this outcome even more likely than Nash equilibriumpredicts. Since this point is very hard for standard economic theory to capture,it has largely been passed over. But it reinforces the point that a sealed-bidauction is in many circumstances more likely than an ascending auction toattract entry, and this will often have a substantial effect on the relative profit-abilities of the auctions.
The 3G auctions provide good examples of over-sensitivity to the
significance of information revelation and affiliation at the expense ofinsensitivity to the more important issue of entry. For example, the Neth-erlands sold five 3G licenses in a context in which there were also exactlyfive incumbent mobile-phone operators who were the natural winners,leaving no room for any entrant. (For competition-policy reasons, bidderswere permitted to win no more than one license each). The problem ofattracting enough entry to have a competitive auction should thereforehave been uppermost in planners’ minds. But the planners seem insteadto have been seduced by the fact that ascending auctions raise (a little)extra revenue because of affiliation and also increase the likelihood of anefficient allocation to those with the highest valuations.29 The plannerswere probably also influenced by the fact that previous spectrum auctionsin the United States and United Kingdom had used ascending designs,30even though they had usually done so in contexts in which entry was less
29 It seems unlikely that the efficiency of the Netherlands auction was much improved by the
30 We discuss the UK design below. The design of the US auctions, according to McMillan
(1994, p. 151–2) who was a consultant to the US government, was largely determined by faith inthe linkage principle and hence in the revenue advantages of an ascending auction in the presenceof affiliation; the economic theorists advising the government judged other potential problemswith the ascending design ‘‘to be outweighed by the bidders’ ability to learn from other bids in theauction’’ (McMillan, 1994) (see also Perry and Reny, 1999). Efficiency was also a concern in thedesign of the US auctions.
of a concern, and even though some US auctions did suffer from entryproblems. The result of the Netherlands auction was both predictable, andpredicted (see, e.g. Maasland (2000) and Klemperer (2000b) quoted in theDutch press prior to the auction). There was no serious entrant.31 Revenuewas less than a third of what had been predicted and barely a quarter ofthe per capita amounts raised in the immediately preceding and immedi-ately subsequent 3G auctions (in the United Kingdom and Germanyrespectively). The resulting furor in the press led to a ParliamentaryInquiry.
By contrast, when Denmark faced a very similar situation in its 3G auctions
in late 2001—four licenses for sale and four incumbents—its primary concernwas to encourage entry.32 (The designers had both observed the Netherlandsfiasco, and also read Klemperer (2000b).) It chose a sealed-bid design (a‘‘fourth-price’’ auction) and had a resounding success. A serious entrantbid, and revenue far exceeded expectations and was more than twice the levelsachieved by any of the other three European 3G auctions (Switzerland,Belgium and Greece) that took place since late 2000.
The academics who designed the UK sale (which was held prior to the
Netherlands and Danish auctions) also thought much harder about entryinto their 3G auction.33 The United Kingdom had four incumbent opera-tors, and when design work began it was unclear how many licenses itwould be possible to offer given the technological constraints. We realizedthat if there were just four licenses available it would be hard to persuadea non-incumbent to enter, so we planned in that case to use a designincluding a sealed-bid component (an ‘‘Anglo-Dutch’’ design) to encou-rage entry. In the event, five licenses were available so, given the UKcontext, we switched to an ascending auction, since there was considerableuncertainty about who the fifth strongest bidder would be (we ran the
31 There was one entrant who probably did not seriously expect to win a license in an ascending
auction—indeed it argued strongly prior to the auction that an ascending auction gave it very littlechance and, more generally, reduced the likelihood of entry into the auction. Perhaps it competedin the hope of being bought off by an incumbent by, for example, gaining access rights to anincumbent’s network, in return for its quitting the auction early. The Netherlands governmentshould be very grateful that this entrant competed for as long as it did! See section 5.3.2 andvan Damme (2002) for more details.
32 Attracting entry was an even more severe problem in late 2001 than in early summer 2000
when the Netherlands auction was held. The dotcom boom was over, European telecoms stockprices at the time of the Danish auction were just one-third the levels they were at in the Dutchauction, and the prospects for 3G were much dimmer than they had seemed previously.
33 I was the principal auction theorist advising the Radiocommunications Agency which
designed and ran the UK auction. Ken Binmore led the team and supervised experimentstesting the proposed designs. Other academic advisors included Tilman Bo¨rgers, JeremyBulow, Philippe Jehiel and Joe Swierzbinksi. Ken Binmore subsequently advised the Danishgovernment on its very successful auction. The views expressed in this chapter are minealone.
U S I N G A N D A B U S I N G A U C T I O N T H E O R Y
world’s first 3G auction in part to ensure this; see section 4.5).34 Thirteenbidders entered, ensuring a highly competitive auction which resulted inthe highest per capita revenue among all the European and Asian 3Gauctions.
The received auction theory also assumes bidders play non-cooperatively inNash equilibrium. We have already discussed how Nash equilibrium maybe a poor prediction because of ‘‘strategic uncertainty’’ and the failure ofthe common priors assumption, but a more fundamental problem is thatplayers may behave collusively rather than non-cooperatively. In particular,a standard ascending auction—especially a multi-unit ascending auction—often satisfies all the conditions that elementary economic theory tells usare important for facilitating collusion, even without any possibility ofinteraction or discussion among bidders beyond the information communi-cated in their bids.
For example, Waterson’s (1984) standard industrial organization text-
book lists five questions that must be answered affirmatively for firms tobe able to support collusion in an ordinary industrial market: (1) can firmseasily identify efficient divisions of the market? (2) Can firms easily agreeon a division? (3) Can firms easily detect defection from any agreement?(4) Can firms credibly punish any observed defection? (5) Can firms deternon-participants in the agreement from entering the industry? In a multi-unit ascending auction: (1) the objects for sale are well defined, so firmscan see how to share the collusive ‘‘pie’’ among them (by contrast withthe problem of sharing an industrial market whose definition may not beobvious); (2) bids can be used to signal proposals about how the divisionshould be made and to signal agreement; 3) firms’ pricing (i.e., bidding) isimmediately and perfectly observable, so defection from any collusiveagreement is immediately detected; (4) the threat of punishment for defec-tion from the agreement is highly credible, since punishment is quick andeasy and often costless to the punisher in a multi-object auction in whicha player has the ability to raise the price only on objects that the defector
34 With five licenses, the licenses would be of unequal size, which argued for an ascending
design. Note that in some contexts an ascending design may promote entry. For example, whenPeter Cramton, Eric Maskin, and I advised the UK government on the design of its March 2002auction of reductions in greenhouse gas emissions, we recommended an ascending design toencourage the entry of small bidders for whom working out how to bid sensibly in a discriminatorysealed-bid auction might have been prohibitively costly. (Strictly speaking the auction was adescending one since the auction was a reverse auction in which firms were bidding to sellemissions reductions to the government. But this is equivalent to an ascending design for astandard auction to sell permits.) (Larry Ausubel and Jeremy Bulow were also involved in theimplementation of this design.) See Klemperer et al. (forthcoming).
will win;35 and (5) we have already argued that entry in an ascendingauction may be hard.
So collusion in an ascending auction seems much easier to sustain than in an
‘‘ordinary’’ industrial market, and it should therefore be no surprise thatascending auctions provide some particularly clear examples of collusion,as we illustrate below.
By contrast, a first-price sealed-bid auction is usually much more robust to
collusion: bidders cannot ‘‘exchange views’’ through their bids, or observeopponents’ bids until after the auction is over, or punish defection from anyagreement during the course of the auction, or easily deter entry. But, perhapsbecause auction theorists have little that is new or exciting to say aboutcollusion, too little attention has been given to this elementary issue in prac-tical applications.
In the Austrian 3G auction, for example, twelve identical blocks of spec-
trum were sold to six bidders in a simultaneous ascending auction (bidderswere allowed to win multiple blocks each). No one was in the least surprisedwhen the bidding stopped just above the low reserve price with each bidderwinning two blocks, at perhaps one-third the price that bidders valued themat.36 Clearly the effect of ‘‘collusion’’ (whether explicit and illegal, or tacit andpossibly legal) on revenues is first-order.
Another elegant example of bidders’ ability to ‘‘collude’’ is provided by
the 1999 German DCS-1800 auction in which ten blocks of spectrum weresold by ascending auction, with the rule that any new bid on a block had toexceed the previous high bid by at least 10 percent.37 There were just twocredible bidders, the two largest German mobile-phone companies T-Mobiland Mannesman, and Mannesman’s first bids were 18.18 million deutsch-marks per megahertz on blocks 1–5 and 20 million deutschmarks per MHzon blocks 6–10. T-Mobil—who bid even less in the first round—later said‘‘There were no agreements with Mannesman. But [we] interpreted
35 For example, in a multi-license US spectrum auction in 1996–97, U.S. West was competing
vigorously with McLeod for lot number 378, a license in Rochester, Minnesota. Although mostbids in the auction had been in exact thousands of dollars, U.S. West bid $313,378 and $62,378 fortwo licenses in Iowa in which it had earlier shown no interest, overbidding McLeod, who hadseemed to be the uncontested high-bidder for these licenses. McLeod got the point that it wasbeing punished for competing in Rochester, and dropped out of that market. Since McLeod madesubsequent higher bids on the Iowa licenses, the ‘‘punishment’’ bids cost U.S. West nothing(Cramton and Schwartz, 2000).
36 Although it did not require rocket science to determine the obvious way to divide twelve
among six, the largest incumbent, Telekom Austria probably assisted the coordination when itannounced in advance of the auction that it ‘‘would be satisfied with just two of the 12 blocks offrequency on offer’’ and ‘‘if the [five other bidders] behaved similarly it should be possible to getthe frequencies on sensible terms’’, but ‘‘it would bid for a third frequency block if one of its rivalsdid’’ (Crossland, 2000).
37 Unlike my other examples in this chapter this was not a 3G auction; however, it is highly
relevant to the German 3G auction which we will discuss.
U S I N G A N D A B U S I N G A U C T I O N T H E O R Y
Mannesman’s first bid as an offer.’’ (Stuewe, 1999, p. 13). The point is that18.18 plus a 10 percent raise equals 20.00. It seems T-Mobil understoodthat if it bid 20 million deutschmarks per MHz on blocks 1–5, but did notbid again on blocks 6–10, the two companies would then live and let livewith neither company challenging the other on the other’s half. Exactly thathappened. So the auction closed after just two rounds with each of thebidders acquiring half the blocks for the same low price, which was asmall fraction of the valuations that the bidders actually placed on theblocks.38
This example makes another important point. The elementary theory that
tells us that ‘‘collusion’’ is easy in this context is important. The reader maythink it obvious that bidders can ‘‘collude’’ in the setting described, but that isbecause the reader has been exposed to elementary undergraduate economictheory. This point was beautifully illustrated by the behavior of the subjects inan experiment that was specifically designed to advise one of the bidders inthis auction by mimicking its setting and rules: the experimental subjectscompletely failed to achieve the low-price ‘‘collusive’’ outcome that wasachieved in practice. Instead ‘‘… in [all] the [experimental] sessions thebidding was very competitive. Subjects went for all ten units in the beginning,and typically reduced their bidding rights only when the budget limit forcedthem to do so’’ (Abbink, Irlenbusch, Rockenbach, Sadrieh, and Selten, 2002). So the elementary economic theory of collusion which makes it plain, bycontrast, that the ‘‘collusive’’ outcome that actually arose was to be expectedfrom more sophisticated players does matter—and I feel confident that thevery distinguished economists who ran the experiments advised their biddermore on the basis of the elementary theory than on the basis of the experi-ments.39
Both the United Kingdom’s and Denmark’s academic advisors gave
considerable thought to preventing collusion. Denmark, for example, notonly ran a sealed-bid auction, but also allowed bidders to submit multiplebids at multiple locations with the rule that only the highest bid made byany bidder would count, and also arranged for phony bids to besubmitted—the idea was that bidders could not (illegally) agree to observeeach other’s bids without fear that their partners in collusion would double-
38 See Jehiel and Moldovanu (2001b) and Grimm, Riedel, and Wolfstetter (2003). Grimm et
al. argue that this outcome was a non-cooperative Nash equilibrium of the fully specified game. This is similar to the familiar industrial organization point that oligopolistic outcomes that wecall ‘‘collusive’’ may be Nash equilibria of repeated oligopoly games. But our focus is onwhether outcomes look like competitive, non-cooperative, behavior in the simple analyses thatare often made, not on whether or not they can be justified as Nash equilibria in moresophisticated models.
39 Abbink, Irlenbusch, Rockenbach, Sadrieh, and Selten (2002) write ‘‘The lessons learnt from
the experiments are complemented by theoretical strategic considerations’’. Indeed, auctionspolicy advice should always, if possible, be informed by both theory and experiments.
cross them, and nor could bidders observe who had made bids, or howmany had been made.40
To be effective, economic advice must also be sensitive to the organizationaland political context; it is important to be realistic about how advice will beacted on. Economic advisors commonly explain a policy failure with theexcuse that ‘‘it would have been okay if they had followed our advice’’. Butmedical practitioners are expected to take account of the fact that patients willnot follow their every instruction.41 Why should economic practitioners bedifferent? Maybe it should be regarded as economic malpractice to give advicethat will actually make matters worse if it is not followed exactly.
For example, the economic theorists advising the Swiss government on its
3G auction favored a multi-unit ascending auction, apparently arguing alongthe standard received- auction-theory lines that this was best for both effi-ciency and revenue. But they recognized the dangers of such an auctionencouraging ‘‘collusive’’ behavior and deterring entry, and the advisors there-fore also proposed setting a high reserve price. This would not only directlylimit the potential revenue losses from collusion and/or inadequate entry but,importantly, also reduce the likelihood of collusion. (With a high reserveprice, bidders are relatively more likely to prefer to raise the price to attemptto drive their rivals out altogether, than to collude with them at the reserveprice; see section 3.4.1; Brusco and Lopomo, 2002b.)
But serious reserve prices are often unpopular with politicians and bureau-
crats who—even if they have the information to set them sensibly—are oftenreluctant to run even a tiny risk of not selling the objects, which outcome theyfear would be seen as ‘‘a failure’’.
40 In the United Kingdom’s ascending auction, the fact that bidders were each restricted to
winning at most a single object, out of just five objects, ruled out tacit collusion to divide the spoils(provided that there were more than five bidders). More important, the large number of biddersexpected (because the United Kingdom ran Europe’s first 3G auction; see section 4.5) also madeexplicit (illegal) collusion much less likely (see chapter 5) and the fact that the United Kingdomretained the right to cancel the auction in some circumstances also reduced bidders’ incentive tocollude.
41 Doctors are trained to recognize that some types of patients may not take all prescribed
medicines or return for follow-up treatment. Pharmaceutical companies have developed one-dose regimens that are often more expensive or less effective than multiple-dose treatments, butthat overcome these specific problems. For example, the treatment of chlamydial infection by asingle dose of azithromycin is much more expensive and no more effective than a 7 day course ofdoxycycline; there is a short (2 month) course of preventive therapy for tuberculosis that is bothmore expensive, and seems to have more problems with side effects, than the longer 6 monthcourse; and the abridged regimen for HIV1 women who are pregnant (to prevent perinataltransmission) is less effective than the longer, more extensive treatment.
U S I N G A N D A B U S I N G A U C T I O N T H E O R Y
The upshot was that no serious reserve was set. Through exit, joint-venture,
and possibly—it was rumored—collusion,42 the number of bidders shrank toequal the number of licenses available, so the remaining bidders had to payonly the trivial reserve price that had been fixed. (Firms were allowed to winjust a single license each.) The outcome was met with jubilation by the biddersand their shareholders; per capita revenues were easily the lowest of any of thenine western European 3G auctions, and less than one-thirtieth of what thegovernment had been hoping for.43 Perhaps an ascending auction togetherwith a carefully chosen reserve price was a reasonable choice. But an ascend-ing auction with only a trivial reserve price was a disaster, and the economic-theorist advisors should have been more realistic that this was a likelyoutcome of their advice.44
4.4.1 Economic Similarity – Political Similarity
Hong Kong’s auction was another case where designers should perhaps haveanticipated the political response to their advice. The Hong Kong auction’sdesigners, like Denmark’s, had observed the Netherlands fiasco (and had alsoread Klemperer, 2000b). So they were keen to use a sealed-bid design, givenHong Kong’s situation.45 Specifically, they favored a ‘‘fourth-price’’ sealed-
42 Two bidders merged the day before the auction was to begin, and a total of five bidders quit in
the last four days before the auction. At least one bidder had quit earlier after hearing from its biddingconsultants that because it was a weaker bidder it had very little chance of winning an ascendingauction. Furthermore, the regulator investigated rumors that Deutsche Telekom agreed not toparticipate in the auction in return for subsequently being able to buy into one of the winners.
43 In fact, when the denouement of the auction had become clear, the Swiss government tried to
cancel it and re-run it with different rules. But in contrast to the UK auction (see note 40), thedesigners had omitted to allow themselves that possibility.
The final revenues were 20 euros per capita, compared to analysts’ estimates of 400–600 euros
per capita in the week before the auction was due to begin. Meeks (2001) shows the jumps inSwisscom’s share price around the auction are highly statistically significant and, controlling forgeneral market movements, correspond to the market believing that bidders paid several hundredeuros per capita less in the auction than was earlier anticipated.
44 I am not arguing that an ascending auction plus reserve price is always bad advice, or even that it
was necessarily poor advice here. But advisors must make it very clear if success depends on a wholepackage being adopted, and should think carefully about the likely implementation of their proposals.
Greece and Belgium did set reserve prices that seem to have been carefully thought out, but they
were perhaps encouraged to do so by the example of the Swiss auction, and of the Italian and Austrianauctions which also had reserve prices that were clearly too low, even if not as low as Switzerland’s.
45 In Hong Kong, unlike in the Netherlands and Denmark, there were actually more incumbents
than licenses. But not all Hong Kong’s incumbents were thought strong. Furthermore, it is muchmore attractive for strong firms to form joint ventures or collude with their closest rivals prior to astandard ascending auction (when the strengthened combined bidder discourages entry) than priorto a standard sealed-bid auction (when reducing two strong bidders to one may attract entry). Soeven though the difference in strength between the likely winners and the also-rans seemed lessdramatic in Hong Kong than in the Netherlands and Denmark, a standard ascending auction stillseemed problematic. So there was a very serious concern—well-justified as it turned out—that astandard ascending auction would yield no more bidders than licenses.
bid design so that all four winners (there were four licenses and firms couldwin at most one license each) would pay the same fourth-highest bid—charging winners different amounts for identical properties might both beawkward and lead to cautious bidding by managements who did not want torisk the embarrassment of paying more than their rivals.46
However, the designers were also afraid that if the public could observe the
top three bids after the auction, then if these were very different from the pricethat the firms actually paid (the fourth highest bid), the government would becriticized for selling the licenses for less than the firms had shown themselveswilling to pay. Of course, such criticism would be ill-informed, but it couldstill be damaging, because even well-intentioned commentators find it hard toexplain to the general public that requiring firms to pay their own bids wouldresult in firms bidding differently. Thus far, nothing was different from thesituation in Denmark. However, whereas the Danish government simplyfollowed the advice it was given to keep all the bids secret and reveal onlythe price paid, the Hong Kong government felt it could not do this.
Openness and transparency of government was a big political issue in the
wake of Hong Kong’s return to Chinese rule, and it was feared that secrecywould be impossible to maintain. The advisors therefore proposed to run anauction that was strategically equivalent (i.e., has an identical game-theoreticstructure and therefore should induce identical behavior) to a fourth-priceauction, but that did not reveal the three high bids to anyone.47 To achievethis, an ascending auction would be run for the four identical licenses, butdropouts would be kept secret and the price would continue to rise until thepoint at which the number of players remaining dropped from four to three. Atthis point the last four (including the firm that had just ‘‘dropped out’’) wouldpay the last price at which four players remained in the bidding. Since nothingwas revealed to any player until the auction was over, no player had anydecision to make except to choose a single dropout price, in the knowledgethat if its price was among the top four then it would pay the fourth-highestdropout price; that is, the situation was identical from the firm’s viewpoint tochoosing a single bid in a fourth-price sealed-bid auction. But, unlike inDenmark, no one would ever see the ‘‘bids’’ planned by the top three winners
46 In a simple model, if a winning bidder suffers ‘‘embarrassment costs’’ which are an increasing
function of the difference between his payment and the lowest winning payment, then bidders areno worse off in expectation than in an auction which induces no embarrassment costs, but theauctioneer suffers. This is a consequence of the revenue equivalence theorem: under its assump-tions, mechanisms that induce embarrassment costs cannot affect bidders’ utilities (it is irrelevantto the bidders whether the ‘‘embarrassment costs’’ are received by the auctioneer or are socialwaste), so in equilibrium winning bidders’ expected payments are lower by the expected embar-rassment costs they suffer. (See chapter 1, exercise 5.)
47 I had no direct involvement with this auction but, embarrassingly, I am told this ‘‘solution’’
was found in a footnote to Klemperer (2000b) that pointed out this method of running a strate-gically equivalent auction to the uniform fourth-price auction, and that it might (sometimes) bemore politically acceptable. See also note 37 to chapter 6.
U S I N G A N D A B U S I N G A U C T I O N T H E O R Y
(and since these bids would never even have been placed, very little credibilitywould have attached to reports of them).
However, although the proposed auction was mathematically (i.e., strate-
gically) equivalent to a sealed-bid auction, its verbal description was verydifferent. The stronger incumbents lobbied vigorously for a ‘‘small change’’to the design—that the price be determined when the numbers dropped fromfive to four, rather than from four to three.
This is the ‘‘standard’’ way of running an ascending auction, and it recreates
the standard problem that entry is deterred because strong players can bidaggressively in the knowledge that the winners will only pay a loser’s bid (thefifth bid) and not have to pay one of the winners’ bids.
Revealingly, one of the strong players that, it is said, lobbied so strongly for
changing the proposal was at the same time a weaker player (a potentialentrant) in the Danish market and, it is said, professed itself entirely happywith the fourth-price sealed-bid rules for that market.
The lobbyists’ arguments that their suggested change was ‘‘small’’ and
made the auction more ‘‘standard’’, and also that it was ‘‘unfair’’ to havethe bidders continue to ‘‘bid against themselves’’ when there were just fourleft, were politically salient points, even though they are irrelevant or mean-ingless from a strictly game-theoretic viewpoint.48 Since the academic consul-tants who proposed the original design had very little influence at the higherpolitical levels at which the final decision was taken, and since perhaps not allthe ultimate decision-makers understood—or wanted to understand—the fullsignificance of the change, the government gave way and made it.49
The result? Just the four strongest bidders entered and paid the reserve
price—a major disappointment for the government, and yielding perhapsone-third to one-half the revenue that had been anticipated (allowing formarket conditions). Whether other potential bidders gave up altogether,or whether they made collusive agreements with stronger bidders not toenter (as was rumored in the press), is unknown. But what is certain isthat the design finally chosen made entry much harder and collusionmuch easier.
It is not clear what the economic theorists advising should have recom-
mended. Perhaps they should have stuck to a (fourth-price) sealed-bid auctionrun in the standard way, but used computer technology that could determinethe price to be paid while making it impossible for anyone other than thebidders to know the other bids made.
48 The lobbyists also successfully ridiculed the original design, calling it the ‘‘dark auction’’,
arguing that it ‘‘perversely’’ hid information when ‘‘everyone knows that transparent markets aremore efficient’’, and claiming it was an ‘‘unfair tax’’ since bidders ‘‘paid more than if they had allthe information’’.
49 The highly sophisticated security arrangements that had been made to ensure secrecy of the
dropouts (removal of bidding teams to separate top-secret locations in army camps, etc.) were notaltered even though they had become much less relevant; there was no need to lobby against these.
The moral, however, is clear. Auction designs that seem similar to
economic theorists may seem very different to politicians, bureaucrats andthe public, and vice versa. And political and lobbying pressures need to bepredicted and planned for in advance.
When the designers of the UK 3G auction proposed a design—the Anglo-
Dutch—that was very unattractive to the incumbent operators, it probablyhelped that two alternative versions of the design were initially offered. Whilstthe incumbent operators hated the overall design and lobbied furiously againstit,50 they also had strong preferences between its two versions, and much oftheir lobbying efforts therefore focused on the choice between them. When thegovernment selected the version the operators preferred (the designers actu-ally preferred this version too) the operators felt they had got a part of whatthey had asked for, and it proved politically possible for the government tostick to the Anglo-Dutch design until the circumstances changed radically.51
Another notorious ‘‘political failure’’ was the design of the 1998 Nether-
lands 2G spectrum auction. The EU Commission objected to the Netherlandsgovernment’s rules for the auction shortly before the (EU imposed) deadlinefor the allocation of the licenses. The rules were therefore quickly rewritten bya high-ranking civil servant on a Friday afternoon. The result was an auctionthat sold similar properties at prices that differed by a factor of about two, andalmost certainly allocated the licenses inefficiently.52
Economists are now waking up to the importance of these issues: Wilson
(2002) addresses political constraints in the design of auction markets forelectricity, and Roth (2002) also discusses political aspects of market design. But the politics of design remains understudied by economic theorists, andunderappreciated by them in their role as practitioners.
50 It is rumored that a single bidder’s budget for economic advice for lobbying against the design
exceeded the UK government’s expenditure on economic advice during the entire three-yeardesign process; the lobbying effort included hiring two Nobel prize winners in the hope of findingarguments against the design. See section 6.5.1 for details of the two versions of the design.
51 When it became possible to offer an additional fifth license in the United Kingdom the
design changed—as had been planned for this circumstance—to a pure ascending one (seesection 4.3.1).
52 See van Damme (1999). This auction also illustrates the potential importance of bidders’
errors: although high stakes were involved (the revenues were over 800 million euros) it seems thatthe outcome, and perhaps also the efficiency of the license allocation, was critically affected by abidder unintentionally losing its eligibility to bid on additional properties later in the auction; it hasbeen suggested that the bidder’s behavior can only be explained by the fact that it happened on‘‘Carnival Monday’’, a day of celebrations and drinking in the south of the Netherlands where thebidder is based (van Damme, 1999)! (The German 3G auction described below provides anotherexample of the large role that bidder error can play.)
U S I N G A N D A B U S I N G A U C T I O N T H E O R Y
Any consultant new to a situation must beware of overlooking issues that arewell understood by those with more experience of the environment. Thedanger is perhaps particularly acute for economic theorists who are used toseeing the world through models that, while very elegant, are often lacking inreal-world detail and context.
The German 3G auction illustrates the importance of the wider context. As
we described in section 4.3.2, in Germany’s 1999 DCS-1800 auction Mannes-man used its bids to signal to T-Mobil how the two firms should divide theblocks between them and end the auction at a comparatively low price. T-Mobil then cut back its demand in exactly the way Mannesman suggested,and Mannesman followed through with its half of the ‘‘bargain’’ by alsocutting back its demand, so the auction ended with the two firms winningsimilar amounts of spectrum very cheaply.
It seems that Mannesman used the same advisors in the 3G auction that it
had used in the GSM auction. Although the rules for the 3G auction were notidentical, it was another simultaneous ascending auction in which individualbidders were permitted to win multiple blocks. After the number of biddershad fallen to six competing for a total of twelve blocks, and when it was clearthat the other four bidders would be content with two blocks each, Mannesmanapparently signaled to T-Mobil to cut back its demand to just two blocks.53 IfT-Mobil and Mannesman had both done this the auction would have ended atmodest prices. Instead T-Mobil seemingly ignored Mannesman’s signals, anddrove up the total price 15 billion euros before cutting back demand. OnceT-Mobil did cut back its demand, Mannesman followed, so the auction endedwith the allocation that Mannesman had originally signaled but with each ofthe six firms paying an additional 2.5 billion euros!
It seems that Mannesman’s advisors saw the GSM auction as a template for
the 3G auction; they took the view that, following previous practice, Mannes-man would signal when to reduce demand, T-Mobil would acquiesce, andMannesman would then follow through on its half of the bargain.54 Thebargain would be enforced by firms not wishing to jeopardize their futurecooperation in subsequent auctions (including 3G auctions in other countries)and in negotiating with regulators, etc. (and the short-run advantage that could
53 According to the Financial Times (3 November 2000, p. 21), ‘‘One operator has privately
admitted to altering the last digit of its bid … to signal to other participants that it was willing toaccept a small license.’’
54 It seems that another reason why Mannesman expected the firms to coordinate by T-Mobil
reducing demand first in response to Mannesman’s signals was that Mannesman saw itself asthe leading firm in the market. However, T-Mobil may not have seen Mannesman as theleading firm—the two firms were closely matched—and this seems to have contributed tothe problem.
be gained by failing to cooperate was anyway probably small; see Klemperer,2002 and sections 7.5–7.8). But given their expectation that T-Mobil wouldcut back demand first, Mannesman’s advisors were unwilling to reducedemand when T-Mobil did not.
Clearly, T-Mobil’s advisors saw things differently. It seems that their
main advisors had not been involved in the GSM auction and the exampleof the previous auction was certainly not in the forefront of their minds. Instead they mistrusted Mannesman’s intentions, and were very unwilling tocut back demand without proof that Mannesman had already done so. Truethe 3G auction was a much more complicated game than the GSM auctionbecause of the other parties involved, and sections 5.4.1 and 7.5–7.8discusses other factors that may have contributed to the firms’ failure toreduce demand.55 But T-Mobil’s refusal to cut back demand very likelystemmed partly from viewing the 3G auction in a different, and narrower,context than Mannesman did.
Just as previous auctions within any country might have been an important
part of the wider context, auctions in other countries are also relevant parts ofthe broader environment: the sequencing of the 3G auctions across countrieswas crucial. Countries that auctioned earlier had more entrants, becauseweaker bidders had not yet worked out that they were weaker and quit theauctions, because stronger bidders had not yet worked out how and with whomto do joint ventures, and because complementarities between the values oflicenses in different countries reinforced these effects—the number of entrantsin the nine western European auctions were (in order) 13, 6, 7, 6, 6, 4, 3, 3, and5 respectively.56 Countries that auctioned earlier also suffered less from‘‘collusive’’ behavior, because bidders had had less practice in learning howbest to play the game. For example, when the Austrian 3G auction followedthe German 3G auction that we have just described, using almost the samedesign, all the bidders very quickly saw the mutual advantage of coordinatinga demand reduction (see section 4.3.2).57
The UK government’s advisers anticipated this pattern of declining compe-
tition, and chose to run its auction first; indeed we persisted in the policy ofrunning the first auction even when others were advising us to delay. Yet inmore than one country auction theorists advising on 3G auction design seemedeither unaware of (!), or at least unaffected in their thinking by, the fact that
55 In particular, the firms might have been concerned about their relative performances (see also
Grimm, Riedel, and Wolfstetter, 2002; Jehiel and Moldovanu, 2002; Ewerhart and Moldovanu,2002).
56 Furthermore, the number (6) achieved in the second auction (Netherlands) was perhaps
lowered by the peculiarly incompetent design; the number (5) achieved in the last auction(Denmark) was raised by its design, which was very skillful except in its timing (see section4.3.1). Of course, other factors, in particular the fall in the telecoms stock price index, may havecontributed to the fall in the number of entrants.
57 Chapter 5 develops the arguments in this paragraph in much more detail.
U S I N G A N D A B U S I N G A U C T I O N T H E O R Y
there was to be a sequence of auctions across Europe. Clearly these designershad far too narrow a view of the problem.58
Of course, other auctions are only the most obvious aspects of the wider
context that auction designers need to consider. There are many other waysin which designers showed themselves very poor at thinking about thewider game. For example, many of the 3G auction designers had a verylimited understanding of how the auction process affected, and was affectedby, the series of telecom mergers and alliances that the advent of 3Gengendered—in the United Kingdom alone, there were no fewer than fivemergers involving the four incumbent 2G operators, in less than a yeararound the auction.59
I have argued that while a good understanding of elementary undergraduateeconomic theory is essential to successful auction design, advanced graduateauction theory is often less important. It is important to emphasize, therefore,the crucially important role that advanced formal theory plays in developingour economic understanding. In particular, advanced theory often developsdeeper connections between apparently distinct economic questions than aresuperficially apparent.
For example, chapter 2 demonstrates that auction-theoretic tools provide
useful arguments in a broad range of mainstream economic contexts. As afurther illustration, I will discuss how a part of the received auction theory—the effect of affiliation—that was, I have argued, not central to the auctions of3G licenses, can develop useful insights about the economics of the ‘‘m-Commerce’’ industry that 3G will create.60
4.6.1 Do e-Commerce and m-Commerce Raise Consumer Prices?
Some commentators and regulators have expressed concern that e-commerceand m-commerce (‘‘mobile commerce’’ in which people purchase through
58 Some of the incumbent bidders, by contrast, may possibly have had a clearer understanding.
In an interesting example of the importance of political pressures, the Dutch operators successfullylobbied to delay the Netherlands auction and the clear gap that was thereby created between theBritish and Dutch auctions may have been a contributory factor to the Dutch fiasco.
59 Section 7.3 gives another illustration of how real-world context that was non-obvious to
outsiders was important to the UK 3G auction.
60 Section 2.2 uses the other main piece of the received auction theory—the revenue equiva-
lence theorem—to solve a war of attrition between several technologies competing to become anindustry standard in, for example, 3G (see also Bulow and Klemperer, 1999) and to compute thevalue of new customers to firms when consumers have switching costs as they do for, for example,3G phones (see also Bulow and Klemperer, 1998). Section 2.3.1 also uses auction theory toaddress how e-commerce (and likewise m-commerce) affects pricing.
their mobile phones, and which is predicted to expand rapidly as a result of 3Gtechnology) allow firms to easily identify and collect information about theircustomers which they can use to ‘‘rip them off’’.61
A simple analysis realizes that each consumer is analogous to an auctioneer,
while firms are bidders competing to sell to that consumer. As we discussed insection 4.2, bidders’ expected profits derive from their private information,and the auctioneer generally gains by reducing the amount of bidders’ privateinformation. So if all firms learn the same piece of information about a givenconsumer, this (weakly) reduces the private information that any bidder hasrelative to the other bidders, and so often benefits the auctioneer, that is,lowers the consumer’s expected transaction price.
Although this result is a good start, it is neither very novel,62 nor does it
address the bigger concern that e-and m-commerce allow different firms tolearn different information about any given consumer. However, Bulow andKlemperer (forthcoming) show how to use the mathematics of affiliation toaddress this issue too; in our model, even if firms learn different informationabout the consumers, this makes the market more competitive. In other words,a quick application of Milgrom and Weber’s (1982a) analysis suggests that the‘‘loss of privacy’’ caused by 3G and the internet is actually good for consu-mers.
Of course, having been cautious about the practical significance of
affiliation in auction design, we should also be cautious about assertingthat Bulow and Klemperer’s argument shows that 3G is not as valuable tofirms as some people once thought.63 However, our model suggests apossibility which needs further study—including considering any empiri-cal evidence and the plausibility of the intuitions—to confirm or discon-firm. Moreover, it certainly demonstrates that just because firms learnmore about consumers, it does not follow that they can exploit thembetter—just as the RET refutes any simple presumption that one formof auction is always the most profitable. Our analysis therefore showsthat firms’ learning has other effects in addition to the very obvious onethat firms can price-discriminate more effectively, and it helps us to seewhat these effects are64—we can then consider further whether theseeffects are plausibly significant. It also provides a structure which suggests
61 The US Federal Trade Commission has held hearings on this issue, and the European
Commission is currently studying it. Amazon has admitted charging different prices to differentconsumers.
62 Thisse and Vives (1988), Ulph and Vulkan (2001), and Esteves (forthcoming), for example,
63 Of course, there are more important reasons why 3G is no longer thought as valuable as it
64 In this case, while a firm may raise prices against consumers who particularly value its
product, in a competitive environment it will also lower prices to other consumers who like itless—and other firms will then have to respond.
U S I N G A N D A B U S I N G A U C T I O N T H E O R Y
what other factors not in the simplest model might in fact be important,and might perhaps yield the originally hypothesized result.65 And it veryquickly and efficiently yields results that provide a good starting point forsuch further analysis.
Bulow and Klemperer pursue these issues in the context of this specific appli-
cation. Chapter 2 considers a range of other applications, including some that atfirst glance seem quite distant from auctions. The moral is that the ‘‘receivedauction theory’’ is of great value in developing our understanding of practicalissues. But it needs to be used in conjunction with developing intuition andgathering empirical evidence to check its applicability to specific situations.
This chapter is not attacking the value of economic theory. I have argued thatelementary economic theory is essential to successful economic policy. Furthermore, the methods of thinking that undergraduate economics teachesare very valuable, for example, in understanding the important distinctionbetween Hong Kong’s two superficially similar auction designs (the oneproposed and the one actually implemented). I have focused on examplesfrom auctions, but the more I have been involved in public policy (for exam-ple, as a UK Competition Commissioner), the more I have been impressed bythe importance of elementary undergraduate economics.
Nor is this chapter intended as an attack on modern, or sophisticated, or
graduate economics. True, the emphasis of some graduate courses is mislead-ing, and the relative importance of different parts of the theory is not alwayswell understood, but almost all of it is useful when appropriately applied; it isnot true that all economic problems can be tackled using undergraduateeconomics alone.66
Policy errors are also less likely when expertise is not too narrowly focused
in one subdiscipline—for example, auction designers should remember theirindustrial economics and political economy (at least) in addition to pureauction theory.
65 For example, the analysis shows that even though it may be no bad thing for consumers if
different firms learn different pieces of information about them, the result depends on firmslearning the same amount of information about any given consumer. It probably is costly for aconsumer to ‘‘lose his privacy’’ to only one firm, just as having asymmetrically informed biddersmay be a bad thing for an auctioneer. Furthermore, even when firms learn the same amount ofinformation about consumers’ tastes, this information may sometimes lead to inefficient price-discrimination which reduces total welfare, in which case consumers may be made worse off eventhough firms’ profits are lowered, just as inefficient auctions may be bad for both auctioneers andbidders. Learning information may also affect firms’ abilities to collude, and the ease of new entry.
66 Furthermore, it is often only the process of thinking through the sophisticated graduate theory
that puts the elementary undergraduate theory in proper perspective.
While advanced theory can be misapplied, the correct answer is not to shy
away from it, but rather to develop it further to bring in the important issuesthat have been omitted. It may sometimes be true that ‘‘a little bit too mucheconomics is a dangerous thing’’, but it is surely also true that a great deal ofeconomic knowledge is best of all. Moreover auction theory also illustratesthat when a subdiscipline of economics becomes more widely used in practicalpolicy making, its development becomes more heavily influenced by thepractical problems that really matter. Like a rapidly growing bush, theorymay sometimes sprout and develop in unhelpful directions, but when prunedwith the shears of practical experience it will quickly bear fruit!
Furthermore, advanced economic theory is of practical importance in devel-
oping our economic understanding of the world, even when it cannot bedirectly applied to an immediate practical problem. To recapitulate only theincomplete list of its merits that was illustrated by our example in section 4.6,it refutes over-simple arguments, makes precise and quantifies other argu-ments, allows us to see the relationship between superficially unconnectedproblems, organizes our ideas, brings out the important features of problems,shows possibilities, and quickly develops general results which, even whenthey are not final answers, provide good starting points for further analysis.
Nevertheless, the main lesson of this chapter is that the blinkered use of
economic theory can be dangerous. Policy advisers need to learn fromMarshall’s example to beware of the wider context, anticipate political pres-sures, and, above all, remember that the most sophisticated theory may not bethe most relevant.
Bird flu fear has gripped the globe, as the disease spreads. Public Health officials fear that a pandemic will occur if a recent strain of the virus, which has killed one-half of the humans it has infected, mutates into a form that can be transmitted between people. The virus has only infected humans who came into contact with contaminated birds. The strain (called H5N1) has kil