Thursday, April 20, 2006

Brilliant explanation of real-world auction theory

This is a book review posted at here.

Paul Klemperer was the principal auction theorist advising the UK Government on the design of the 3G spectrum auction in 2000, which raised $34 billion, the biggest auction in history. In this book he reviews auction design both theoretically and in practice - the two perspectives turn out to be very different.

Chapter 1 is a survey of auction theory. The author begins by identifying four types of auction: the English type of open ascending bids, the Dutch auction using descending bids where the first bidder wins, the first-price sealed-bid auction where the highest bidder wins and pays their own bid price, and the second-price sealed-bid auction (the Vickrey auction) where the highest bidder wins, but pays the amount bid by the second-highest bidder. If the latter seems counter-intuitive, note that in the English auction, the winner also pays an amount set by the second-highest bidder (the last person to drop out). Note also that the Dutch auction and the first-price sealed-bid auction are equivalent.

Another important distinction is between private-value auctions, where each bidder has their own, invariant valuation of the object(s) being auctioned, and common-value auctions, where bidders might alter their valuations depending on signals (i.e. observed bids) made by other participants.

The key result in auction theory is the Revenue Equivalence Theorem, which states that all the standard auction methods, under certain plausible conditions, generate the same revenues. This accounts for the fact that no one method of conducting auctions has displaced all the others. However, practical considerations often favor one kind of auction design over another, and this is analyzed extensively later in the book.

Chapter 1 finishes with a mathematical appendix which proves some of the main results plus some questions (and answers) from the Oxford University MPhil economics examination.

Chapter 2 is titled ‘why every economist should learn some auction theory’ and extends application of the theory to economic issues such as litigation models, wars of attrition, market crashes and trading frenzies, and Internet sales models.

Chapter 3 is a detailed guide to auction design. Auction theory is about mathematical models and their properties. Auctions in the real world are competitions where real money is at stake and any and all tactics will be employed to win. Critical tactics to ‘game’ auctions include collusion between bidders to avoid bidding against each other therefore lowering prices for everyone, and predatory behavior, where weaker bidders are frightened off either before or during the auction, thereby clearing the field and closing the auction early. Examples are given of extraordinary behavior by bidders which succeeded in effectively wrecking auctions as revenue-generating vehicles. Klemperer analyses each of the four types of auction in the context of deterring such behavior and concludes that there is no one right answer: auction design is ‘horses for courses’.

Chapter 4, ‘using and abusing auction theory’, is aimed at academic auction theorists seduced by the mathematics at the expense of real-world issues. Klemperer argues that ‘undergraduate economics’, taking into account the concerns of industrial organisation (e.g. monopolistic, oligopolistic and perfectly competitive behaviours) are more central to successful auction design than some of the more ‘sophisticated’ topics of the graduate-level theory. He also emphasises, with examples, that political realities can negate even the best auction design, if the designer is naive and doesn’t take politics into account in advance.

Chapter 5 gives an overview of the European 3G spectrum auctions, which ranged from brilliantly successful to absolute disasters, while chapter 6 explains in great detail exactly how the UK auction (perhaps the most successful) was designed. This chapter is extremely insightful in indicating how many general economic intuitions have to be employed, over and above the specific insights of auction theory, to get a design which can resist the best efforts of the bidders to sabotage its effectiveness.

Chapter 7 analyses some of the more interesting and puzzling bidder strategies seen in the auctions, while chapter 8 is the reprinted Financial Times article, ‘were auctions a good idea’, which defends the idea of auctions against special pleading by industry lobbyists that they had to pay too much, and that as a consequence the industry was wrecked. Not so.

Overall, this book succeeds in creating in the non-economist reader a sense that they understand the basic terrain of auctions - what they are about - although there is clearly a much deeper set of theoretical results underpinning this map of the territory. The chapters tend to be quite repetitive, but that can help offset Klemperer’s use of jargon whenever he gets into conceptual analysis. It looks as though he doesn’t know he’s doing it, and that the people who reviewed it are his colleagues who use this stuff every day and didn’t notice either. With a small amount of additional explanation to clarify the use of terms, much of the conceptual analysis would have been more accessible. The alternative is to read the book twice! Recommended.