The Royal Swedish Academy of Sciences awarded the 2020 Nobel Memorial Prize in Economics to Paul R. Milgrom and Robert B. Wilson “for improvements to auction theory and inventions of new auction formats.”

What is auction theory and why is the laureates’ work so important?

Imagine a local government that wants to grant a concession to build a highway between two cities. The government does not have the resources to build the highway itself nor does it know how much it will cost. They decide to organise a procurement auction for construction companies and award the concession to the company with the lowest bid. The government wants to ensure that it pays the least amount of taxpayers’ money to get the highway built properly. It would also prefer companies to bid on the true cost of construction rather than have bids distorted by strategic speculation.

What is the auction format that would achieve these goals? Should the bidders submit their bids secretly; or announce them publicly, one by one? Should the winner be paid exactly their bid, or the bid submitted by the company who got the second place? Maybe another specific amount?

These are not easy questions. To find the right approach, the auction designer must also consider the bidders’ point of view. How do the bidders formulate their bids based on their construction costs? What do the bidders think about their competitors’ costs? And what do they think about how their competitors formulate their bidding strategies?

The questions become even more complicated when multiple items are auctioned at the same time, such as in a radio frequency auction. The work of Paul Milgrom and Robert Wilson helps us find the answers.

Economic theory is often criticised for focusing on abstract problems that are disconnected from reality. It is also too often claimed that its rigorous yet elegant results are far from applicable to everyday economic problems.
This is certainly not the case with auction theory. Its most important results – including the work of this year’s laureates – are used worldwide in the practical design of auctions for radio frequencies, electricity capacity and similar objects. The success of auction theory is a great example of how scientific breakthroughs – even theoretical ones – can benefit our society.