Search for the Nobel Prize website under Economic Sciences – Prizes in Economic Sciences 2020 – Popular Information and you’ll find the above heading with this year’s Laureates, Paul Milgrom and Robert Wilson, addressing auction theory.
When I first came across this topic I had to ask myself, has such a high profile award got to do with the Australian real estate auction market? After a close reading of the awards summary the immediate answer was ‘yes’. Milgrom and Wilson have held a spotlight onto some core and some surprising aspects of real estate auctions, but also much more broadly and I can easily admit their almost forensic studies gave me further enlightenment.
Auctions have been a frequent topic of mine. The last detailed post was in February 2017 when I looked at how valid auctions were in helping to set house prices at a time when prices were said by some commentators to be artificially high!
My conclusion at the time was that real estate auctions were infact the most reliable time to set a valid market price for any property. And setting a price for an entire raft of products is discussed at length in the work by Milgrom and Wilson that won the Noble Prize, over two posts I’ll try to sum up the published highlights.
Auctions have a long history
By way of introduction we’re told that auctions have a long history. The Romans used auctions to sell confiscated assets for bad debts, while he world’s oldest auction house, Stockholm’s Auktionsverk, was founded in 1674.
Nowadays, auctions are not only associated with property but also traditional farm auctions, high end art auctions, telecommunications spectrum, while in a more recent move auctions online have also started to spread to buying property.
Auction outcomes also impact areas of everyday living via the public procurement of government contracts by companies placing the lowest bid. Another example quoted is flexible electricity prices, which can be determined with regional electricity auctions.
And we are increasingly familiar with how all countries now secure loans by selling government bonds in auctions. So, Milgrom and Wilson rightly point out that auctions affect all of us at almost every level, something that we become acutely aware of if buying a property at auction.
This heading caught my attention, as an insight to help us know a little more about auction theory. The Laureates’ note that the outcome of an auction depends on three factors.
The first is the auction’s rules, or format. That is, are the bids open or closed? How many times can anyone bid in the auction and under what terms [for property in NSW that would include being a registered bidder] ? What price does the winner pay?
The second factor relates to the auctioned object. Does it have a different value for each bidder, or do they value the object in the same way? I found this a complex but one very much related to property, that I’ll return to.
The third factor concerns uncertainty. What information do different bidders have about the object’s value? In the property market this also appears relevant and reminds me of the often quoted advice to buyers – “ do your homework.”
Using auction theory, according to the prizes’ notes, it is possible to explain how these three factors influence the bidders’ strategic behaviour and the auction’s outcome and how the auction can create as much value as possible.
We are all familiar with the two most common formats; the English auction and the Dutch auction. The former being by far the most common format for property.
With the English auction, the auctioneer begins with a price [usually a lower price], and subsequently suggests increasingly higher prices. Bidders can see all the bids and choose whether they want to place a higher bid. Whoever places the highest bid wins the auction and pays the price, job done.
A Dutch auction starts with a high price, which is then gradually lowered until the object is sold, the format is not generally common, and I’ve not seen it used for real estate. However, what is most relevant, and essential when it comes to considering how a final price is arrive at, is that both English and Dutch formats have open bids, so all participants see the others’ bids. Thus, they are ‘public auctions.
The most common reason for a property to go to auction is to get the “best price.” Private sellers are usually most concerned with getting the highest price.
According to Milgrom and Wilson and others in their field the quest for the best auction and by extension the best price is a tricky problem that economists have been thinking of for a long time. And I suspect they are not alone!
The difficulty ahead of any auction is what will be any bidder’s best strategy and what each other potential bidder might bid in the auction. For instance, do some bidders believe the object [property] is worth more or less than others? And we also see that they most certainly do.
Does the level of a higher or lower bid naturally lead to the conclusion that reflects some bidders possibly having better information about the characteristics and value of a property?
The 1996 a previous Laureate in Economic Sciences, William Vickrey, established auction theory in the early 1960s, that in part relates to ‘private’ and ‘common’ values. This is a fascinating discussion and I’ll continue this topic in my next post, further exploring how Milgrom and Wilson have explored the fundamentals of auction theory and in particular how auctions determine value.