Part 7 (1/2)
The saaued that the allocation of public assets, froht to use radio spectruht to be detera coovernh stakes and, to use an old phrase, force each negotiator to ”put his aovernhts throughout the second half of the 1990s This was not an easy task: a coo license ht want both of them, or neither, because it is cheaper to run adjacent networks But how to bid sensibly on Los Angeles before knoill get San Di-ego? This is a coaned a cohly successful (and very lucrative for the govern The theorists had got the coht butthe bids without rounding thee bybids which contained area codes This allowed thenal which licenses they'd prefer, and so carve up the US telecoainst each other This schereenals It looked like cheating, but nobody could prove it Three years after the first auctions, an auction in April 1997 raised less than 1 percent of the ex-pected revenue because, clai competition with each other
This is the equivalent of selling your 300,000 house for less than 3,000 It seeht hap-pen, but it's simple If there are only a sree aainst each other The one who buys the house cheaply needs to find some way to compensate the others The ree not to bid against them in future auctions In the sa not to bid against each other for spectruaiven away the li-censes for nothing
An alternative way of seeing the probleame theorists failed to see that what they had analyzed was only part of a wider gaovernment was like the poker player blissfully unaware of hidden cameras in the room; oblivious to the fact that the other players, by a series of nods and winks, are taking turns winning his ame at all
Ga at auctions or cheating at cards, it aa assumptions be-fore they can beassump-tions (for example, that bidders won't use area codes to coordinate a carve-up) then they will produce perfect solutions to the wrong problees of all is rooted in the very origins of game theory: it was developed by men of nearly super-hureat strength and its great weakness, because for gaht into what mere mortals do Game theory expresses the way people would act as the solu-tion to a mathematical equation It presumes hyperrational play-ers who are able instantly to solve very tough problea how real people actually behave Nash and Von Neumann really could solve such problea because in theory its outcome is predetermined: one player can force a result However, we do not knohether it is black or white that can force the result, we do not knohether the forced result is a win or a draw, and we certainly do not kno the game would be played We only know that in theory, the forced result is possible In practice even the strongest players (coy, and in practice the outco prede-termined So what use is a theory that tells us that chess would be trivial, if only ere all sh to kno to play it?
Not all of us think like a genius Most of us would try to bluff at poker with a halfway good hand; Von Neumann showed that the correct play is to bluff with the worst possible hand Chris ”Jesus” Ferguson, a disciple of Von Neumann, proved it when he won the World Series of Poker in 2000 But poker with your buddies in the garage is not the World Series; what can gaet drunk and bluff badly?
This is not a knockdown objection to gaetfulness, misinformation, and any other kind of failure on the part of the players to live up to the ih standards of John Von Neumann The trouble is that the more mistakes that need to be taken into account, the aame theorist to draw on experience as well as pure theory, because if the game becomes too complex for the players to understand, then the theory becomes nearly useless for practical purposes since it tells us nothing about what they will actually do
Enter the auctioneers In late 1996, I saw one of the country's leading auction theorists illustrating this point-in passing-in a seame theory to auctions As part of his talk, Paul Klemperer confis-cated the wallets of two members of the audience, counted the money they contained, and then offered to sell that (unknown) suh-est The two members of the audience, put on the spot, were quite unable to work out what the opti in the auction
The difficulty-which is a challenge for bidders inspectrum auctions-is that the two victi for They knew part of the value, of course, because they kneabout the contents of the other's wallet In a spectrum auction, the probley plans, but each knows that other bidders will probably have dif-ferent insights The optie of any information revealed by other players' bids-but this is not easy (In the wallet ga until he reaches twice the sum in his oallet The player with the fatter wallet would win but pay less than the coressively risks paying too much) The failure of the two dumbfounded ”volunteers” to work out how to bid in the auction was ers, theaers were about to beconed the eneration” (3G) cell-phone services
They had two serious difficulties to wrestle with First, to avoid being out bidders as the US authorities had been Second, even if they couldn't find the optiy for each others' auctions on the spot, how could they expect a collection of businessame theory predicts? And if those businessht happen?
John Maynard Keynes, the ed for a day when econoer archtheorists but instead, ”rather like dentists,” consulted to fix everyday problehtforward advice Eco-nomics is not there yet, and any economist ishes to be even half as helpful as a dentist must temper economic theories with heavy doses of the hard lessons of real life: players cheat; bidders aaovernment, which auctioned radio spectrum as early as 1990 with advice frorasp on reality, learned such lessons the hard way The auctions were held withoutsure that there was any interest fro a theoretical curiosity called a ”Vickrey auction,” which led to considerable embarrassment (The auction was named after its inventor, nobel laureate Williaame theory to auctions) The Vickrey auction is a second-price sealed-bid auction The ”sealed bid” le bid and seals it in an envelope When the envelopes are opened, the high-est bidder wins ”Second-price” is the curious rule that the win-ner pays not his bid but that of the second-highest bidder The elegant reasoning behind this auction is that no bidder ever has an incentive to shave his bid in an effort toa lower bid affects his chance of winning but not the price To a theorist, this doesn't seem odd at all: after all, in a traditional auction at Sotheby's or Christies, the price is also set by the second-highest bidder, because bidding stops when the second-highest bidder drops out To the press andshort of crazy The problem with the Vickrey auction is not substantive but stylistic: in a tra-ditional auction nobody ever finds out theto pay, but in a Vickrey auction that fact is made public Justifiably, New Zealanders wanted to knohy a bidder who had offered NZ100,000 (about 72,000) for a license only had to pay NZ6 (4+) or why one who had offered NZ7 (5+)up NZ5,000 (around 3,600) These figures were ee, Vickrey auctions make just aspaye all bidders to offer more But what the theorists knew did not matter to the press and to the public: the harsh reality is that Vickrey auctions were seen as a failure of the New Zealand government
Ga in the US auction Others, such as the public reaction in New Zealand, simply don't show up in the theoretical analysis Economists who aspire to dentistry have to think carefully and learn from mistakes: new ones will continue to be discovered the hard way
Why use an auction?
When the UK governhts, they were taking a bold step After initial success, the US auctions had fallen apart because the game theory used to construct theovern stock And they weren't the only ones: Australia had also run auctions for TV licenses and left loopholes in the bidding rules, which had been so badly exploited that the minister responsible lost his job Why did Britain even consider using an auction, given the risks?
Like the US governovernment wanted to sell the licenses to the companies that could use the so Of course, there was an additional unstated aim: to avoid embarrassment for bureaucrats and politicians alike For the taxpayers of New Zealand and the United States, an auc-tion that raised so the licenses away, but for a politician, giving away public assets is a great way to make friends and allies Auction theorists therefore had to ame theory, which clearly demonstrates the power of si sure that the licenses end up in the right hands With a limited number of licenses it would be a criminal waste if one of them went to timharfordcom, an Internet-bubble company with no relevant experience and no capability to use the valuable as-set The licenses should go, instead, to companies that will use them to deliver the best quality services at the lowest cost Com-petition between license holders will then set prices
So what is the best way to identify the most capable companies? One possibility is simply to ask them, but companies will boast and bluster Some will point to their experience, others to the latest technology But would any really tell the truth? Talk is cheap
Another idea thatis to appoint experts to decide which co world of cell telephony, most experts would have some financial interest in one company or another-who is ex-pert yet totally detached from the industry? Even if a truly im-partial expert could be found, he would still have little success in penetrating trade secrets and judging the true potential of rival technologies
Gah all the coine a straightforward auction of a single license, which is like a traditional auction where bidders yell out higher and higher offers, with one difference: anyone who stays in the rooh bid Anyone who drops out htly different auction is easier for game theory to analyze, but also closely reflects many of the actual auctions used to sell licenses
Each bidder ment about what the license is worth The better their innovative ideas and the cheaper their technology, the more money they will make if they win a license Of course, none of the companies can per-fectly forecast what profits they would make with a license, but each is in a better position than any external expert to ins to rise, bidders will start to drop out once the asking price for the license exceeds their own estimate of its value to them Companies without con-fidence in their business plans and technologies will be the first to go If the price rises a long ithout anyone leaving the room, each bidder learns that the others are confident about the prospects for the market as a whole (This provides the distinc-tion between this auction and a traditional auction at Sotheby's- while a Sotheby's auction is in progress you never knoho is still a potential bidder and who is just watching) If soly early, the rest should take note and revise their own assumptions The auction neatly summarizes the collective wisdom of all the bidders
Meanwhile, nobody is in a position to lie Talk is cheap, but bidding is expensive No company will drop out while the price is still lower than their prediction of the license's value, and no coh In a sense, the auction is like Von Neuame of poker: be-cause money is at stake, the bids have to be taken very seriously In another sense, it is not like poker at all, because the auction makes it absolutely impossible to bluff
The auction forces each bidder to tell the truth about his own estimate of the license's value At the same time, the auction broad-casts the collective view to all the bidders, so that they can update their own opinions accordingly What's more, it collects cash while it does so
Gaenerally a better cash-generatinga sale This is not obvious One alternative would be for the seller to run an auction but to set a reserve price (open or secret) belohich he will not sell Another would be to negoti-ate in secret with several buyers in parallel and lie about how the negotiations were going Or the seller could make a one-shot, ”take-it-or-leave-it” offer to each seller in turn Or so array of possibilities, how can a seller choose thea sale?
Gah to the core of the problem In the mid-1990s, Klemperer and Jeren tea if the simplicity of the auction attracted just one extra serious bidder, that straightforward auction would raiseset-up
In addition to the central claim that auctions really do raise more cash, the paper finally focused the attention of auction theo-rists on what should have been obvious: if you want a successful auction, you need plenty of serious bidders
The UK auction in action The UK auction design team certainly went all-out to make sure those serious bidders turned up By March 2000, the UK auction was ready to go with thirteen registered bidders who had paid 50-million deposits and were hooked up to the Internet to sub- the auc-tion for more than a year in advance and had made sure they were the first European nation to hold an auction for third gen-eration phone licenses The result prohly co obsessively on the details They'd tested the auction design using co the role of telecom execu-tives They crawled over the fine print of the auction, trying to eliave the suspicious appeared to be going on But despite all this preparation, nobody really knew if the auction would work, or whether it would be yet another bungle by the economists
The auction was set to run in short rounds-lasting half an hour or so-during which the bidders had to submit new bids or withdraw Those who chose not to enter a valid bid had to drop out of the auction; each bidder was allowed to ”pass” three ti There would be a couple of rounds every day, maybeprocess Each of the rounds would be posted promptly on the Internet; this auction was to take place in full view of the world
The initial expectations were that the auction h to knock a penny off the UK income tax for the year While the team was obviously nervous, they were thrilled to have nine new co, and they expected the auction to be a success
They attributed the interest from new companies in part to the fact that five licenses were available Originally, the engi-neers had believed that the airwaves could accoths of radio spectru the entire country But with four established companies, an auction for four licenses would have had obvious winners and the new entrants would not have bothered turning up siet beaten The econoineers worked out that there was enough radio spectrum available for one extra license This license, called ”license A,” was reserved for new co in the UK cell-phone market
The idea of the auction was that competition for license A would drive up the prices of the other four licenses Any fir or withdraw; but as long as firal bids, they could switch bids from one license to another The firms would obviously choose to bid on whichever license appeared to offer the best value at the time This meant that the hot competition for li-cense A kept the auctions for the other licenses si nicely-every time the price of A rose above the rest, the other licenses looked like bargains Entrants would peel away and chal-lenge the established companies for the licenses they had staked out for themselves When the established fir on license A
Although the simultaneous auction of five licenses is complex to explain, it is quite siy Because bidders never knohen the auction is going to end, they need to make sure they are always coy is to look at all the li-censes and subh bid on whichever license looks like the best value If none looks like a good value at that tiht move is to withdraw The simplicity of the auction may help to explain why so many companies decided to bid, and un-like World Series Poker or the wallet ga your house in a prolonged auction that goes on for weeks and weeks You've heard the stories about other auc-tions, and you're afraid that instead of getting the 300,000 you expect, you'll end up like your unfortunate neighbor, divorced and penniless The first week is agony But the price slowly starts to rise, and your blood pressure starts to fall Eventually the bid-ding gets to 250,000-you realize that, whatever happens, you're not going to do too badly A few days later the bidding reaches 300,000 and you're set 310,000, or 320,000, or even 350,000 Who knows? Then the price keeps going up It hits 320,000 It reaches 350,000 400,000 500,000 What's happening? You can scarcely believe it
This unexpected turn of events is similar to what happened in the UK spectruher: not 300,000 but 3 billion For a week, the bidding went s kept the total revenue rising steadily After about twenty-five rounds of bidding, bidders were committed to around 400the total stood at 3 billion: what the govern to raise (In coh they had been raised to 100to look a little trivial) But so in the auction All thirteen coularly and the prices of the licenses kept rising without any sign of slowing down
As the auction rolled on, the press started to take interest Photographs of the design tealed to explain exactly what the tea reh round sixty (total revenue: 4 billion) Round seventy (5 billion) Round eighty (7 billion) The end of March ca
The auction designers were keeping quiet about what they thought of all this, but behind closed doors they were both ex-cited and nervous The auction was beco There were jitters on the US stock market-what if a stock-market crash spread to the UK, destroyed the confidence of the bidders, and brought the whole auction to a sudden stop? The deposit of a 100 million suddenly looked pretty small Maybe the bidders would just walk away Perhaps the bidding should be speeded up? It turned out that there was no need to worry