Deadweight
Two Stanford University economists won the Nobel Prize in Economic Sciences this week for “improvements to auction theory and inventions of new auction formats.” Thrilling news for these two scholars, the award was based on theoretical advancements and practical benefits that have great impact on all of us. I’m not kidding. Paul Milgrom and Robert Wilson have advanced the work done by other economists, and also created entirely new and useful ways to “price” incredibly complex goods and services. Think radio spectrum, electricity, troubled debt (it was 11 years ago when the US Government was awash with it), and oil leases on government land. All have been auctioned off over the last thirty years using principles and ideas generated by Milgrom and Wilson. Anybody who has a cell phone should be grateful for their role, and all US taxpayers owe them a hearty “thank you”.
Auctions are a form of trading goods and services. They have been around for centuries and serve us in many ways. An auction bid, or price, reflects a value based on information publically available and, in some cases, stemming from the bidder’s own assessments of the object being sold. Not all buyers have the same information, so better information leads to a better assessment of value, theoretically at least. The New York Stock Exchange operates on a modified auction basis, as do the options and commodities exchanges. If “price is truth”, then auctions are a bedrock of our capitalist system.
Reading the award takes you to a whole different level of trying to understand the complexities of pricing goods and services. What Milgrom and Wilson developed is a new way to help buyers, sellers, and the public at large maximize the OUTCOME of an auction of complex assets. When the Federal Communications Commission auctioned off electromagnetic spectrum, the goal was “to achieve an efficient and intensive use of the spectrum with revenue as the secondary objective”. Yes, the government knowingly entered into the auction placing revenue as secondary to the public good. Milgrom and Wilson helped make it happen.
A much overlooked benefit of the auctions Milgrom and Wilson helped put together is the elimination of “deadweight”. Deadweight is a term for the extra cost associated with having a government involved in a transaction, and deadweight losses can be reduced from 17-56% of every dollar raised in a complex auction. As the Nobel Committee recognized “generating funds through markets rather than taxation avoids costly tax distortions”. The award goes on to state “a higher degree of competition in the market will likely generate higher long-run government revenues AND higher long-run welfare.” Milgrom and Wilson have helped governments around the world improve efficiencies and create greater value to society. I may never understand the “monotone likelihood ratio property,” but I surely do appreciate the value of smarter government thinking and letting free markets efficiently provide goods and services to us all.
Ralph McDevitt October 16, 2020
Any opinions are those of Ralph McDevitt and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Expressions of opinion are as of this date and are subject to change without notice.