C15: Economic Policy Analysis Topic 7: Auctions Tilman Börgers February 2004

Lecture 1: Spectrum Auctions (23 February) Lecture 2: Electricity Auctions (1 March) A revised handout is available on the course web page. General reference: Paul Milgrom (1989), Auctions and Bidding: A Primer, The Journal of Economic Perspectives 3, pp

Lecture 1: Spectrum Auctions

References Paul Milgrom (2000), Putting Auction Theory to Work: The Simultaneous Ascending Auction, Journal of Political Economy 108, pp Ken Binmore and Paul Klemperer (2002), The Biggest Auction Ever: The Sale of the British 3G Telecom Licenses, Economic Journal 112, pp. C74-C96. Tilman Börgers and Christian Dustmann, Strange Bids: Bidding Behavior in the United Kingdom’s Third Generation Spectrum Auction, available at:

Outline of the Lecture 1.Introduction 2.An Overview of 3G Licensing in Europe 3.Why Auctions? 4.The Simultaneous Ascending Auction 5.The UK Experience 6.Conclusion

1.Introduction Mobile telephone networks use radio spectrum. Spectrum users need permissions (licenses). Licenses are issued by a government agency (in the UK: formerly Radiocommunications Agency, now Ofcom). Around the year 2000, licenses for the next (3 rd ) generation of mobile telephone networks needed to be issued. International agreement had specified spectrum bands and technology (UMTS).

What needed to be determined 1.Number and size of licenses. 2.License holders.

The Objectives 1.Create sustainable competition in the third generation mobile telephone market. 2.Allocate the licenses to the “right” license holders. 3.Raise government revenue.

The Constraints 1.The available spectrum: 2x60 MHz of paired spectrum and 25 MHz of unpaired spectrum. 2.Technological constraints (minimum spectrum: 2x10 MHz paired spectrum).

Method IMethod IIMethod III Mechanism by which the Number and Size of Licenses is determined Bureaucratic Auction Mechanism by which the License Holders are chosen BureaucraticAuction The Methods

Economic theory makes predictions regarding these methods. Before the auction: Recommendations based on theory were made. A variety of methods were tried out. After the auction: Check whether predictions came true. Our focus will be on the UK. But first we give an overview of the European picture.

2. An Overview of 3G Licensing in Europe Method I (Beauty Contest) Finland, Spain, Sweden, Portugal, France, Ireland, Luxembourg Method II (Auctions With Exogenous Licenses) UK, Netherlands, Italy, Belgium, Denmark Method III (Auctions With Endogenous Licenses) Germany, Austria, Greece

CountryNo of Licenses Rev (€ ) per head Method IFinland February Spain December Sweden September Portugal September France January Ireland March Luxembourg March The Results

CountryNo of Licenses Rev (€ ) per head Method IIUK March Netherlands June Italy September Belgium February Denmark September

CountryNo of Licenses Rev (€ ) per head Method IIIGermany July Austria November Greece July

3. Why Auctions? Objective: “Put licenses into the hands of those who value them the most.”  Allocate licenses so that the sum of valuations is maximized. Promote competition.

How to maximise the sum of license valuations? Identical licenses: Give to the bidders with the highest valuations. Heterogeneous licenses: More complicated.

Example: One small license (S), one large license (L). Solution: A gets S and B gets L. Marginal valuations matter! BidderValue for SValue for L A911 B47

Example (continued): One small license (S), one large license (S). Solution: A gets S and B gets L. BidderValue for SValue for L A911 B47 C56

The key problem: The government doesn’t know the valuations. The solution: Auctions. Competitive bidding reveals values. Competitive bidding maximizes the sum of valuations.

4. The Simultaneous Ascending Auction A very rough classification of auctions: Single Unit Auctions Multi-Unit Auctions Sealed Bid Auctions Open Bid Auctions x

Open, Multi-Unit Auctions The most prominent open, multi-unit auction is the “simultaneous ascending auction”. The “simultaneous ascending auction” is the most popular auction format for spectrum auctions. It is often attributed to Milgrom, Wilson, McAfee, … Here we study it in the simplest context: Multi- unit supply, but single-unit demand.

Simultaneous, Ascending Auction Rules: All licenses are auctioned simultaneously. Bidding starts at minimum bids. In each round, the currently leading bidders are committed to their bid, and can’t change it. All other bidders have to overbid one currently leading bid by a minimum increment, or drop out. Bidding continues until the number of active bidders = number of licenses. Bidding on all licenses closes at the same time.

Straightforward Bidding: Surplus = Value of a license – Minimum bid. Bid for the license for which surplus is maximised. Bid the minimum bid. Theorem: Straightforward bidding is rational (a Nash equilibrium). Under straightforward bidding, licenses are allocated so that the sum of valuations is maximised. (Milgrom, 2000)

Example (continued) Bid price of L up to 1. C switches to S Bid price of L up to 2. A switches to S, and then switches back and forth. When price of S reaches 5, C drops out. A wins S and B wins L. BidderValue for SValue for L A911 B48 C56

Why is the Theorem true? Straightforward bidding is rational (a Nash equilibrium)… At the time at which a bid is placed, you get the highest surplus. If prices of other licenses go up, your choice looks even better. If your bid is overbid, then you can still switch on other licenses.

Is it always best to bid straightforwardly? Not if the others play a strategy of the type “Bid the price of license X up, if bidder Y ever bids for license X”. Yes if the others also bid straightforwardly. This is why the Theorem only says that it is a Nash equilibrium to bid straightforwardly.

Under straightforward bidding, licenses are allocated so that the sum of valuations is maximised… Suppose some other license allocation had a higher sum of valuations. Then also the difference between sum of valuations and current prices were higher. Then some bidder would have to have a higher surplus in the new allocation. Why did this bidder not bid for this license?

5. The UK Experience I focus on the case of the UK. There were five licenses: 2 large ones (A and B), and 3 small ones (C, D and E). The 4 incumbents were not allowed to bid for A. There were 13 bidders. 6 March April rounds.

The Winners: Incumbents in red LicenceCompanyWinning Bid ATIW£ 4,384.7 m BVodafone£ 5,964.0 m CBT3G£ 4,030.1 m DOne2One£ 4,003.6 m EOrange£ 4,095,0 m

The Losers: CompanyWithdrew in Round NTL Mobile150 Telefonica133 Worldcom121 One.Tel100 Epsilon98 Spectrumco97 3GUK95 Crescent94

Our main question: Did bidders reveal consistent marginal valuations? Under straightforward bidding: bid for large license if v L -p L > v S -p S  p L -p S < v L -v S Valuation differences should be revealed by bids.

Possible Interpretation of BT’s Behaviour: Naïve rule of thumb (minimize £/MHz) Easy to justify towards shareholders. Drive up the price that Vodafone has to pay.

Possible Interpretation of TIW’s Behaviour: Strategy change after the first phase. Tried to conceal their true identity in phase 1.

Possible Interpretation of NTL Mobile’s Behaviour: Learning in the first phase. Budget constraints in the last phase.

6. Conclusion More research is needed to understand bidders’ motivation structure in license auctions. The outcome of the UK auction might have been efficient … … but not for the reasons we expected. Auction designs need to be tested further.

Open Questions Do we need to license use of the radio spectrum (“Open Spectrum Movement”)? Should licenses specify the use that is made of the spectrum? Should we allow trade in licenses? Should license trade be regulated? How does trade in licenses affect bidding in license auctions? Do customers get a good deal when firms have to pay high license fees?