The 2020 Nobel Prize in Economics: Explained

the asparagus rix bank prize in economic sciences in memory of alfred nobel or simply the nobel prize in economics is an award given every year to thought leaders in the field this is one of six prizes given out the others recognising similarly high achievers in literature physics medicine chemistry and of course the peace prize awarded for furthering the betterment of humanity in and amongst all of the happenings in the world this year these awards have kind of flown under the radar which is unfortunate because they all recognized some very remarkable works and in the field of economics it all had to do with auctions auctions to the average person might sound like a pretty mundane thing you hop on ebay and bid for that new rtx 3080 before crying yourself to sleep or maybe you are bidding for a new house to live in at a property auction at the extreme end we see options for works of art that sell for millions of dollars but even still the auction itself kind of just looks like a formality around which transactions are done but this is far from true auctions and auction theory are one of the most important systems to understand in economics because they act as an efficient way to build markets and correctly determine how we value items remember amongst everything economics is simply a study of how people interact with things of value so with that in mind what should the average person or aspiring economist know about auction theory what did the winners of this year's nobel prize contribute to this theory and how can this be utilized to build better and more efficient economies this episode of economics explained is brought to you by acorns successful investors disagree on many things and ultimately it's the net some of those disagreements which makes markets but if there's one thing that successful investors do agree on it's that you not only need to have financial goals but also a plan to achieve your financial goals and that is where acorns comes in thanks to helpful features like their compound interest calculator you can easily calculate how much you should be setting aside to achieve your target retirement nest egg i really like this tool because you can adjust variables like your recurring investments or even roundups of your spare change stay tuned until the end to learn more or sign up now at acorns.com ee and acorns will deposit five dollars into your portfolio to help you get started that's acorns.com ee the link is on the screen now and in the video description below now the first thing to know about auctions is that they are surprisingly complicated there is so much more going on beyond a room full of people with paddles and what's more is that this can all be changed based on the rules of the game the hopeful outcome of any auction or any transaction for that matter is that the seller gets the best possible price they can for what they are selling so to achieve this result here is what to know about auctions the outcome of an auction also known as procurement depends on three main factors the first is the auction's rules or format are the bids open where everyone knows what the current highest bid is or is it a silent auction where all bids are submitted anonymously without anybody else knowing what the current highest bidder is or even by whom it was submitted the second factor relates to the auctioned object does it have a different value for each bidder like say a family heirloom for sale at an estate auction or is it all the same to every bitter like say a generic piece of consumer electronics the third factor concerns uncertainty what information do different bidders have about the object's value is there a publicly listed valuation or is it something with lots of similar sales information like real estate or is it something very obscure and opaque like let's say an auction for an abandoned storage unit which may be filled with priceless jewelry or might be filled with cobwebs by the way options for storage units do exist and they are extremely entertaining now by tinkering with these factors we can fine-tune auctions to create as much value as possible for everybody involved but before any changes are made by our brilliant nobel laureates here we must first understand what the current arrangements are for modern day auctions auction houses and websites around the world usually use the english system this has nothing to do with the language but just so happened to be used first in english auction houses this is the typical system that you probably think of as an auction where the auctioneer will start at a low price and a selection of potential buyers will consecutively bid higher and higher until one bidder offers a price that nobody is willing or able to beat the idea is that this is an effective way of finding the person that is willing to pay the highest price for the item being sold and it will do exactly that but here is the problem the seller in an auction doesn't want to find the person that is willing to pay the highest price they want to be paid the highest price possible and those two things are not the same consider this there is an auction for a family home and the real estate agent decides to hold an auction to sell the property to keep things simple let's say that there are two parties that register to bid at this auction the first bidder reckons the property is worth about 200 000 but has a home loan approval in place that will let them bid up to 210 000 which is the most that they would be willing to pay the second bidder is a property developer who wants to knock the house down and build a whole lot of apartments on top of the block they are paying all in cash and are willing to spend up to 250 000 because they stand to make a massive profit on their development the bidder starts with the reserve which let's say is 150 000 and then it goes back and forth between these two parties until the price gets to two hundred and ten thousand dollars at which point the developer offers a higher bid of two hundred and fifteen thousand dollars and the regular purchaser can no longer raise so the auction is one for the developer and they got away with spending 35 000 less than what they were actually willing to do the english style auction is by far the most popular type of auction and most people would be forgiven for thinking it's the only type of auction but even still it's a fundamentally flawed system it will never attract the highest possible price it will only ever attract a price one increment higher than the second highest bidder this issue is supposedly solved by a dutch style auction where the price will start really high and then gradually gets lowered until the first person raises their hand people can try and wait out the auction to see if prices will fall further and further in their favor but someone like our developer would be far more inclined to raise their paddle just as soon as the price hits 250 000 because they risk losing out on their profits if there is a bidder willing to pay 245 000 which of course they would have no way of knowing now dutch auctions are great in theory but are exceedingly unpopular because they are seen as slightly unethical by potential buyers and they also remove a lot of the emotions that drive auctions in the real world all of these factors lead to a phenomenon known as the winner's curse our developer would be happy to win the auction but might be a bit cranky to find out that they overpaid by 35 000 this was the first contribution to auction theory by our brand new nobel laureates paul milgrom and robert wilson you see these guys are behavioural economists and they realize that people don't always behave in absolutely the most logical way what they found was that the less people knew about the transactions the less that they were willing to beard if a regular person was to attend a regular english auction and see lots of people bidding for a house that they know is in a good area with good schools they will think okay well obviously there is demand for this house and they will throw their bid in it's almost a type of herd mentality where people feel much safer as part of a group of buyers rather than being the first to stick their hand up in a dutch style auction am i paying too much is there something i'm missing will i ever be able to sell this house are all fearful questions that bitter will get answered in a regular auction that they would not in a dutch auction because of this what the nobel laureates research found was that in a competitive auction the sellers could expect to receive roughly the same price from both an english auction and a dutch auction information shortfalls like these also create another major problem for a potential winner they might not always get all that they wanted to pay for in our example the developer is willing to spend a lot of money on this particular family home this is not because they want to live in it or maybe even because the property is actually worth that much but rather it is because they will be able to turn a profit from developing a block of units on that land this is where the nobel laureates draw a distinction between different types of values which are private and common values common values are normally what we think of when we think of value and that's the value that an item will sell for if someone wants to evaluate the market price for a property in question that would be a common value now different parties will have different ideas as to what this value actually is but it pretty much boils down to guesswork about what an asset would trade for on the open market this question actually gets answered in real time during a regular english auction private values are a little bit different though this is how individual parties value a particular item distinct from any other buyers a buyer might be willing to pay ten thousand dollars above market price for a property if it's right next door to their best friend or they might only be willing to pay ten thousand dollars below market value if it's right next door to their in-laws in the case of our entrepreneurial investor their private value all has to do with their ability to turn this family home into a block of units but here's where it gets weird to build this apartment the developer might need to buy both this house as well as the property next to it now because they can turn such a great profit by building these units they are willing to offer well above the common value of the property and bid 250 000 for this house but let's say the developer buys this house and then it turns out the people living in the next house don't want to sell well suddenly this block of land becomes pretty much useless to them they could sell it off but they won't get as much as they paid for it or they could hold on to it and they'd just have an average house sitting there doing nothing what's more is that the people in the houses surrounding the one that the developer bought will probably be made aware of their plans and hold out on selling their home knowing that the developer will have to raise their offering price higher and higher or be stuck with the sunk cost of a house that they just want to knock over this kind of situation is the mother of all winners curses and it means that the developer might not actually be willing to bid at all and every party loses out if people are uncertain about being able to realize their private value they won't be competitive participants in an option this leads us neatly on to the next major problem with auctions and that is the assumptions that they are nothing but competitive we always hear about anti-competitive behaviour when it comes to selling things large corporations that corner the market for gasoline water medicine or whatever else and then jack up the price to make massive profits or maybe it's a group of corporations all acting together to achieve exactly the same results most developed economies around the world have a government agency specifically to look out for anti-competitive behaviour because it is illegal the thing is though that this type of price tampering is just as commonplace on the other side of the transaction bidding collusion is a big issue plaguing auctions let's go back to our auction for that family home if those two bidders were able to talk to one another they might be able to influence the outcome to their advantage the developer might say look i have more money than you so i am going to win this auction no matter what but if i give you ten thousand dollars to not bid at all i can win this auction at a much lower price in this example the developer could then just bid slightly higher than the auction reserve and win the property changing their outer pocket from 215 000 to just one hundred and fifty five thousand plus the ten thousand dollars they gave to the regular buyer saving them forty thousand dollars and giving the regular buyer an extra ten thousand dollars they can put towards buying a bigger and better house to live in now in most nations this is still illegal but it is much much harder to track a company buying up all of its competitors is very clear to see and even price collusion has competitive risk go and watch our video on game theory to find out why but for most buyers this type of system is pretty much risk-free if anybody is questioned by the authorities they will just say that they didn't like that particular property and even if the developer doesn't make good on their promise to pay them that ten thousand dollars well that's okay they aren't in any worse of a situation if a business doesn't sell its product it will hurt that business if buyers don't buy something it doesn't mean anything they just hold on to their money and wait for the next auction to come along in this example it's not like the regular buyer is going to win anyway so there is literally no downsides to colluding and failing to bid now regular options for things like regular homes attract lots of bidders these are more akin to regular markets with lots of competition that makes collusion pretty hard but there are auctions where only a few companies or individuals in the world have the interest and the ability to make a purchase these situations are almost the mirror image of an oligopoly where there are only a few sellers in a particular market and collusion is possible in fact there is actually a name for this it's called an oligopoly so so far it sounds like auctions are very problematic they don't generate the best price and they lend themselves to collusion what's more is that so far we've only been looking at extremely simple auctions with a small number of parties and a seller who is only interested in getting the best price of course getting the best price is extremely important for most sellers but for some it isn't everything since the mid-1990s auctions have been increasingly used by governments in the distribution of complex public assets things like privatized infrastructure sales natural resources radio frequencies or basically any large-scale asset that a government is looking to sell off now in these instances price is important but it is not everything a government will be more eager to sell a mine site to a company with a good track record of employing local workers protecting the local environment and returning profits back to local investors over a company that will pay more but do none of these things if traditional auction formats can't even find the best price for the seller what possible hope do they have for fulfilling all of these other requirements this is where our nobel laureate stepped in again and provided an award-winning solution so far we have been using the example of a simple auction for a family home where just two parties are bidding and the seller only cares about the best price but to really test this theory to the extreme we're going to explore the exact same example that the royal swedish academy of sciences used when awarding this prize the hypothetical problem was how would the swedish government design an auction that achieves the efficient allocation of radio frequency bands the ones that companies use to build cell phone networks while at the same time benefiting taxpayers to the greatest possible extent again there is no point selling off these assets for a great price if it's only going to a company that will hold the cell service ransom the problem turned out to be very difficult to solve since a frequency band has both private and common value components the value of a specific frequency band in a specific region depends on other frequency bands owned by a specific operator consider an operator who wants to build out a national mobile network say that a swedish regulator auctions off frequency bands one by one starting in lapland in the north and odd ones across the country all the way down to skein in the south now the value of the lapland license depends on whether the operator in later rounds succeeds in buying licenses all the way down and at what price they can get those later licenses for again all very similar to our developer needing to get that second house to build their apartment complex the operator does not know the outcomes of future auctions so it's impossible to know how much they should pay for the license in addition speculative buyers may try to purchase the exact frequency band the operator needs in skeins so they can sell it back to them at a higher price in the second hand market to tackle these problems milgram and wilson invented an entirely new auction format the simultaneous multi-round auction this was developed in collaboration with preston mcafee no not that mcafee but a brilliant economist nonetheless this auction offers all objects simultaneously in this case all radio frequency bands in all different geographic areas it will start with low prices and allow bidders to silently post their bids at the end of the first round all of the current top bids for all the frequencies in all of the areas are revealed and the bidders can once again try to outbid each other or withdraw their bid for the next round this process is continued over and over and over again until one round is completed where no withdrawals are made or bids are placed this sounds simple enough but think of the problems that it solves it means that companies will only be buying a full collection of assets that they actually want and they will be buying it at a price that they are happy paying which means they are willing to bid more because they don't have the fear of getting stuck with only half of the assets they want to make their developments work it also avoids bitter collusion because all of the assets are sold at once the bidders either play the game or they miss out it does this all while eliminating any chance for corruption as well because all bids are competitive and publicly available so there is no chance for any special treatment it also reduces the stress that comes along with typical dutch or silent auctions that a bidder may be over bidding because they still get the comfort of seeing that they are competing against their peers that are happy to pay similar prices what makes this all the more remarkable is that milgram and wilson didn't just use this to write a great theoretical paper they actually implemented it paul milgram is the co-founder and chairman of octonomics which is a company that provides auction software to facilitate the exact same auction structures that won him his nobel prize the fcc which is the agency responsible for radio frequencies in the usa first used simultaneous multi-round auctions in july of 1994 when it sold 10 licenses in 47 bidding rounds for a total of 617 million american dollars where these frequencies had previously been allocated practically for free since then the fcc's auctions alone using this format have brought in more than 120 billion over 20 years and many countries around the world including finland india canada norway poland spain the uk sweden and germany have adopted the same format for the sale of all kinds of public goods the nobel prize is regarded by many including myself as the highest honor one can receive for their academic contributions to the world it's even better to see when these brilliant minds are put towards creating something that works to add genuine value in our day-to-day lives the new auction formats are a beautiful example of how basic research can subsequently generate inventions that benefit society the unusual feature in this example is that the same people develop the theory and the practical applications to make it work in the real world the real world been a particularly foreign place to some economists the laureate's groundbreaking research about auctions has been of great benefit for buyers sellers and society as a whole what's more is that milgram and wilson are not the only nobel laureates whose insights into the economy we are able to take advantage of in fact you can leverage dr harry markowitz's insights to build out your own investment portfolio with acorns thanks to features like roundups investing is as easy as spending simply link your debit or credit card to your acorns account and you're ready to go every time you make a purchase acorns will round up your transactions to the nearest dollar and then automatically set aside that spare change for you right into your diversified portfolio and as if that wasn't awesome enough you can also grow your savings even faster with recurring investments which lets you automatically add to your portfolio every day week or month i'd also be remiss if i didn't mention acorn spend which is the only checking account that provides you with a heavy metal debit card that automatically saves and invests for you as you make purchases even better acorns 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Channel: Economics Explained

Views: 311,776

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Keywords: the nobel prize in economics, auction theory economics explained, how to run an auction economics explained, the economics of running an auction, economics nobel prize 2020, auction theory in economics, what is auction theory in economics, auction theory explained, the economics of the nobel prize, what is the nobel prize of economics, alfred nobel, how does auction theory work economics explained, how does auction theory work, economics explained

Id: R_wxk7Ihyok

Length: 22min 22sec (1342 seconds)

Published: Sun Oct 25 2020