The $120 Billion Idea Behind This Year’s Nobel Prize in Economics

(Bloomberg Businessweek) — You know that feeling of elation when you win an auction—say, a bidding war for a house—and how it’s immediately followed by that sinking feeling that you overpaid? That’s the winner’s curse. It’s a real thing. Once you stop to think, you realize there’s probably a good reason other people weren’t willing to pay as much as you did. By winning, you just lost.

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Understanding the winner’s curse, and how to avoid it, is part of the reason Stanford University economists Robert Wilson and Paul Milgrom won this year’s Nobel Prize in economics—formally called the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (PDF).

Wilson’s and Milgrom’s work is unusual in that it’s both theoretical and highly practical. The U.S. Federal Communications Commission raised more than $120 billion for taxpayers from 1994 through 2014 by selling off wireless frequencies using an auction they designed along with Preston McAfee, then at the University of Texas. Electricity and oil and gas leases are sold using the same idea. More broadly, their ideas have helped economists understand auctions for everything from internet advertising to Treasury bills.

“Both of them are just incredibly bright,” says Princeton University economist Jakub Kastl, who worked with them while teaching at Stanford. “They provide other researchers, me included, with tools on how to approach other auction markets.”

Here’s an historical footnote: In 1996, Milgrom delivered a Nobel lecture on behalf of William Vickrey, who died shortly after winning the prize that year.

But let’s get back to that sinking feeling, the winner’s curse. Its existence was known before the work of Wilson and Milgrom, but they built a theory that explains how it occurs, under what conditions, and how to make it less of a problem.

Take the case of a bidding war for a house. Wilson showed that if the bidders are sensitive to the risk of winner’s curse, they’ll shave their bids to something below what they think the house is really worth, so if they do win they’ll be less likely to have overpaid.

Wilson focused on the case where the bidders care only about the “common value” of the house—for example, they’re all flippers who are thinking only about what they can turn around and resell it for. Milgrom looked at a broader set of cases where bidders care about the common value but have differing “private values”—i.e., the house is worth more to one bidder than another, perhaps because it’s closer to where she works. He showed that the seller will get a higher price if more information about the value is available (such as an independent appraisal) and if bidders learn more about each other’s estimated values during bidding (so the agent shouldn’t conduct a “blind” auction).

Here’s a nice explanation of the work from the Nobel organization. Here’s a Bloomberg Opinion column on the prize by Scott Duke Kominers of Harvard Business School. And here’s a link to a 2003 book by Milgrom, Putting Auction Theory to Work, which he dedicated to Wilson.

 

Read next: What’s Baked Into the Market? And What Does That Even Mean?

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