Going Once, Going Twice, Sold: Auctions and the Success of Economic Theory
Zaretsky, Adam M., Regional Economist
In 1994, the Federal Communications Commission (FCC) began auctioning electromagnetic spectrum bandwidth to firms interested in using it for personal communications services (PCS). Before that time, spectrum bandwidth had been given away to broadcasters through administrative hearings or lotteries-procedures that were not only inefficient, but also costly. According to the Commerce Department, the federal government in the 1980s gave away cellular phone licenses valued at $46 billion.1 Realizing the revenu, potential, Congress turned to auctions as a way to both allo cate spectrum more efficiently than it had in the past and to reap revenue that could be used to help offset the budget deficit. Economists were calle upon to aid in the design and implementation of these auctions, which have proven quite successful.
Why Auctions Are Better
In a word, auctions are better at allocating spectrum than administrative hearings or lotteries because auctions enable market forces to designate who will receive how much of the resource. As with all other resources in the economy, there is a limited amount of spectrum bandwidth; thus, scarcity exists. And like other scarce goods and services in the economy, prices are the best allocator.2
But unlike many other goods in the economy, which are abundantly available and frequently purchased, spectrum bandwidth is difficult to price because, until 1994, it hadn't been sold before. Auctions overcome the pricing problem through their bidding mechanisms, which let potential buyers reveal their individual values of an item. Moreover, because sellers can set the rules of the selling process and announce them upfront, all auction participants know exactly what is expected of themselves and others. In other words, auctions are orderly, organized mechanisms through which market-clearing prices can be determined.
So Why Were
In many ways, bidding for an item at an auction is a lot like playing poker. With each hand, a player has to decide whether to call, raise or fold. He bases this decision on two factors: the cards in his own hand and his best guess as to the cards in the other players' hands. At the same time, he must also try to figure out how the other players might react to his decisions. The understanding and explanation of this behavior is called game theory.
Game theory examines the strategic interaction and decision-making behavior of players in a game, accounting for what they know, what they think others know, and how they think others will act on this knowledge. A wellknown example of the theory is the simple two-person game called the Prisoners' Dilemma. In this game, Bud and Lou commit a crime. Although there is little evidence against them, they are still arrested. The two are separated and told their options. If both confess, each will get four years in prison. If neither confesses, each will be charged with a lesser crime and get a two-year sentence. But if, for instance, Bud cooperates and rats on Lou, who says nothing, Bud will get one year, while Lou will get eight. If Lou rats on Bud, and Bud keeps quiet, the sentences will be reversed.
What should Bud and Lou do? The best option would be for them to agree not to confess so both can get off with only two years in prison. But this strategy requires Bud and Lou to collude and trust each other to uphold their end of the bargain. The trust is tested, though, once the two are separated. If Bud truly believes that Lou will keep quiet, he can cut his sentence from two years to one by taking the deal and confessing. If Lou is thinking exactly the same thing, though, both will end up confessing and, therefore, each will get four years.
As the accompanying table shows, Bud's best strategy is actually to confess irrespective of which strategy Lou chooses (confessing or keeping quiet). 3 Why? Because if Lou chooses to confess, Bud's options are either to also confess and serve four years, or to keep quiet and serve eight. …