Oftentimes, when a Nobel Prize is awarded, it’s hard to even understand what it’s about. But when Paul Milgrom and Robert Wilson were announced as the 2020 Laureates in Economic Science, their topic of research was a familiar one: auctions.
Auctions have likely been around for as long as money has, and while many of us don’t often participate in auctions, they affect our lives in more ways than we imagine. When you see an ad on a website, the odds are it’s not a fixed ad, but an auction where different advertisers are bidding for the advertising space. Landing slots, spectrum frequencies, even gas and electricity, all can be real-world applications of auctions.
Yet despite all this, we’ve only started truly understanding the hidden intricacies of auctions relatively recently. Milgrom and Wilson clearly showed this when they worked on a system to help the US government sell radio spectrum to wireless telephone companies, raising $120 billion for something the government just gave away for free.
Much about auctions revolves around information – the information that the bidders know about the product and about what other bidders are doing. In his lecture at #LINOecon, Wilson took a deep dive into the concept of rational expectations equilibrium and pondered where prices truly come from.
Laureate with Great Influence on Colleagues
Even among Laureates, Wilson stands out. In addition to his own Nobel Prize, three of his students are also Laureates, a testament to how big his influence has been in the world of economics.
Wilson’s trip into economics was an unlikely one, and much of his interest came from curiosity about different types of equilibrium and how sometimes, the market seemed to expect that correct prices would be pulled out of thin air.
„Sixty years ago, I was very mystified by the Walrasian concept of equilibrium. I had taken courses in mathematical economics, and there was a dominant theory called the Walrasian theory of equilibrium, and it miraculously found a price that cleared the market and the resulting allocation was determined by what people bought at those prices,“ Wilson noted in his lecture.
„I had a strong sense that we can do better than this thing of miraculously pulling a price out, he added.“
People look at market prices as informative of things that are not directly observed or imperfectly observed. But there’s a parallel concept of an efficient market, and Wilson wanted to get a better understanding of the rational expectations driving efficient markets. It took decades of work, and during the process, Wilson ended up revolutionising many concepts in economics, but at the end, it was all worth it.
„The kind of motivation I had 60 years ago to start working on auctions, that curiosity is satisfied,“ Wilson concluded.
Adressing Water Scarcity by Auctions
Water scarcity is a problem in many parts of the world and climate change won’t do us any favors. Many water reserves are used unsustainably as it is, and with the added pressure from climate change, water scarcity could easily become one of our biggest challenges this century.
In the face of such a challenge, you’d expect the market to step in and make water usage more efficient, prioritising those who need it most and who are willing to pay more to get it. But when Milgrom looked at what was happening in California, he saw a completely different picture.
California is currently going through a megadrought, the worst in the past 1200 years, which raises pressing water shortage problems. Around 60 percent of California’s water usage comes from surface water (rivers, lakes, etc), and 40 percent of it comes from groundwater. Water in California is allocated through property rights. However, the water market seems pretty inefficient. For instance, when water scarcity hit the hardest in the state, the price of water increases – but the amount of reallocated water doesn’t, Milgrom says.
„In California, less than 5 percent of water is reallocated, even in the most severe drought. The prices adjust, but the reallocation doesn’t adjust even when there is insufficient water. The prices are responsive, but the value of trade isn’t very responsive. So why doesn’t the market work, and what can we do to fix it?“
The Laureate explains that a market based on auctions could help make the system more efficient. Drawing from previous work on the radiospectrum auctions, he proposes that a centralised system in which water can be bought and sold based on who values water most can help tackle water scarcity.
But challenges abound. For instance, if you buy an amount of water, you don’t really get to use that amount of water. Some of it is lost to the soil, or goes down into the aquifer, or is used in the process. If one farmer uses it for agriculture, some of it returns to the system, or can even go back to water used by another farmer. Analysing how much water exists, and how much water flows from where to where is an extremely difficult challenge, which makes understanding the externalities of the system extremely challenging.
Thankfully, recent technological advances have improved our ability to measure water availability and flows. In particular, satellite data has proven useful for this, but the challenge of creating a unified water market is still a challenge – one that Milgrom is currently taking on.
Research with Uber
Later on in the day, a panel featuring Milgrom and Wilson, as well as 2007 Laureate Roger B. Myerson, postdoctoral fellow Angie Acquatella, and moderator Klaus Schmidt from the University of Munich, discussed the impact and implications of auction market design.
Myerson recalled how, right around the time of the fall of the Soviet Union, he got the chance to interact with economists in Moscow, and how foreign the concept of an auction market design seemed to them, as at the time, the Soviet economy was just starting to change from socialism. It’s a testament to the robustness and applicability of auctions that a concept that would have seemed bizarre to much of the world three decades ago is so influential now.
There was also important advice for the younger participants. Myerson recalled how, while attending a conference, a fortuitous meeting with Wilson and Milgrom changed his career.
„I had the privilege of talking to Bob Wilson and Paul Milgrom, and Bob said something about what would be an auction that would make the most possible revenue in a given model, and suddenly, I realised I could do that cause I’ve been calculating a feasible set for a completely different reason that I don’t even want to talk about now.“ So instead, he thought, „why not just maximise the expected revenue?“
Milestone of a Career
The resulting paper would be an important stepping stone to a blossoming career.
The panel also approached another field where auctions could make a big impact: healthcare; and in particular, US healthcare. Unlike most countries that have some form of universal healthcare, US healthcare is so different, complex, and inefficient, that attempting to direct it with auctions would be a „Herculean task,“ says Wilson. But this Herculean task may be worthwhile.
Acquatella notes that she made the switch to healthcare when she was taking an Uber. At the time, another Laureate, Joshua Angrist, was moonlighting as an Uber driver to learn more about the system. Inspired by this, Acquatella quizzed her Uber driver as to why he was working at Uber.
As it turns out, the man had a career working in software, but because of medical problems, was forced to get a second job to pay for his healthcare. This came as a shock and motivated Acquatella to look more into healthcare. Uber-type solutions don’t really work in healthcare, however. A few years back, investors including Jeff Bezos and Warren Buffet tried to „solve“ healthcare with an Uber-type company, but they shut it down after three years – proving that you can’t just throw money at the problem, you need a good framework to work with.
To truly address healthcare (or any other field) with auctions or any type of efficient market design, Milgrom says, you need to understand the big problems and challenges in the field. That’s what he’s doing now with water markets.
Ultimately, auctions have the power to revamp and shape many markets, but they are a tool, and it’s not always clear how to best use this tool. Thanks to work from these pioneers, we’re one step closer to understanding how to use it.