Journalof Economic Perspectives—Volume 16,Number 1—Winter 2002— Pages 169 – 189 What Really Matters inAuction Design PaulKlemperer uctions have becomeenormously popular inrecent years. Governments arenow especiallykeen, using auctions tosell mobile-phone licenses, A operatedecentralized electricity markets, privatize companies and for many otherpurposes. Thegrowth of e-commerce has ledto many business-to- business auctions forgoods whose tradewas previouslynegotiated bilaterally. Economistsare proud oftheirrole in pushing forauctions; forexample, Coase (1959)was among the rstto advocate auctioning theradio spectrum. But many auctions—including some designed with the help of leading academic economists—have workedvery badly. Forexample, six European countries auctioned offspectrum licenses for “third-generation”mobile phones in2000.In Germanyand theUnited Kingdom, thespectrum sold forover 600 euros per person ($80billion in all, or over 2percentof GDP). But in Austria, theNetherlands, Italy and Switzerland,the revenueswere just 100,170, 240 and 20eurosper person, respectively.To besure, investorsbecame more skeptical about theunderlying value of the spectrum during 2000(and theyare even more skeptical today). Butthis isjust afractionof the story. TheNetherlands auction was sandwiched betweenthe U.K. and Germanauctions, and analysts and governmentof cials predicted revenues in excessof 400 euros per person fromthe Italian and Swissauctions just afewdays beforethey began (Michelson, 2000;Roberts, 2000; Total Telecom, 2000; Klemperer, 2002). These otherauctions were ascoes primarilybecause theywere poorly designed. Sowhat makesa successful auction? What reallymatters in auction designare the same issues that any industry y PaulKlemperer istheEdgeworth Professor of Economics,Oxford University, England. His e-mail addressis [email protected] ,andhis website is http://www. paulklemperer.org . 170Journal of Economic Perspectives regulatorwould recognize as keyconcerns: discouragingcollusive, entry-deterring and predatorybehavior. In short, good auction designis mostly good elementary economics. Bycontrast, mostof the extensive auction literature(as summarizedin, for example,Klemperer, 1999a, 2000a) is of second-order importance for practical auction design. Theauction literaturelargely focuses on a xednumber of bidders who bidnoncooperatively, and itemphasizes issues such as theeffects of risk aversion,correlation of information, budget constraints and complementarities. Auction theoristshave madeimportant progress on thesetopics fromwhich other economictheory has bene ted, and auction theoryhas also beenfruitfully applied inpoliticaleconomy, nance, lawand economics, laboreconomics and industrial organization,often in contexts not usuallythough ofas auctions (Klemperer, 2001a).But most of this literatureis of much lessuse foractually designing auctions. This paperwill list and giveexamples of somecritical pitfalls in auction design and discuss what todo about them.We show that ascending and uniform-price auctions areboth veryvulnerable to collusion and verylikely to deter entry into an auction. Weconsiderincluding a nal sealed-bidstage into an otherwise-ascending auction tocreate an “Anglo-Dutch ” auction, and weemphasize the need for strongerantitrust policyin auction markets. Collusion A rstmajor setof concerns forpractical auction designinvolves the risk that participants mayexplicitly or tacitlycollude to avoidbidding up prices.Consider a multiunit(simultaneous) ascending auction. (This isjust likethe standard auction used, forexample, to sell a paintingin Sotheby ’sorChristies —theprice starts low, and competingbidders raise the price until no oneis preparedto bid any higher, and the nal bidderthen winsthe prize at the nal pricebid. However,in this case, severalobjects aresold at thesame time, with the price rising on each ofthem independently,and none ofthe objects is nallysold untilno onewishes to bid again on any ofthe objects.) In such an auction, bidderscan usethe early stages, when pricesare still low, to signal who should winwhich objects and then tacitly agreeto stop pushing up prices. Forexample, in 1999,Germany sold tenblocks of spectrumby asimultaneous ascending auction withthe rule that any newbid on ablockhad toexceed the previoushigh bidby at least10 percent.Mannesman ’s rstbids were18.18 million deutschmarks permegahertz on blocks1 –5and 20millionDM perMHz on blocks 6 –10;the only other credible bidder —T-Mobil— bideven less in the rst round. One ofT-Mobil ’smanagersthen said (Stuewe,1999, p. 13): “Therewere no agreementswith Mannesman. But[T-Mobil] interpreted Mannesman ’s rst bid as an offer.” Thepoint isthat 18.18plus a10percent raise equals approximately 20. It seemsT-Mobil understood that ifit bid20 million DM per MHz onblocks1 –5, PaulKlemperer 171 but did not bidagain on blocks6 –10,the two companies wouldthen liveand let livewith neither company challengingthe other on theother ’shalf. Exactlythat happened. Sothe auction closedafter just tworounds witheach ofthe bidders acquiringhalf theblocks for the same low price ( Jehieland Moldovanu, 2001; Grimm,Riedel and Wolfstetter,2001). Ascending auctions can also facilitatecollusion by offering a mechanism for punishing rivals.The threat of punishment maybe implicit; for example, it was clearto T-Mobil that Mannesman wouldretaliate with high bids on blocks1 –5 if T-Mobilcontinued biddingon blocks6 –10.But an ascending auction can also allowmore explicit options forpunishment. In amultilicenseU.S. spectrumauction in1996 –1997,U.S. Westwas compet- ingvigorously with McLeod for lot number 378: a licensein Rochester,Minnesota. Although mostbids inthe auction had beenin exact thousands ofdollars, U.S. Westbid $313,378 and $62,378for two licenses in Iowa inwhich ithad earlier shown no interest,overbidding McLeod, who had seemedto be the uncontested high bidderfor these licenses. McLeod got the point that itwas beingpunished for competingin Rochester and dropped out ofthat market.Since McLeod made subsequent higherbids on theIowa licenses,the “punishment” bids cost U.S. West nothing (Cramton and Schwartz,1999). Arelatedphenomenon can arisein one special kind of sealed-bid auction, namely a uniform-price auction inwhich each biddersubmits a sealedbid stating what priceit would pay fordifferent quantities of a homogenous good, like electricity(that is, itsubmitsa demand function), and then thegood issold at the singleprice determined by the lowest winning bid. In this format,bidders can submitbids that ensurethat any deviationfrom a (tacitor explicit) collusive agreementis severely punished: each bidderbids veryhigh pricesfor smaller quantitiesthan itscollusively agreed share. Then, ifany bidderattempts to obtain morethan itsagreed share (leavingother rmswith less than theiragreed shares), allbidders will have topay thesevery high prices.However, if everyone sticks to theiragreed shares, then thesevery high priceswill never need to be paid. As a result,deviation from the collusive agreement is unpro table.1 Theelectricity regulator in the United Kingdom believes the market in which distributioncompanies purchase electricityfrom generating companies has fallen preyto exactly this kindof “implicitcollusion ” (Of ceof Gas and Electricity Markets,1999, pp. 173 –174). “Farfrom being the success storytrumpeted around theworld, the story of the U.K. generationmarket and thedevelopment of competitionhas beensomething of a disaster, ” reported Power U.K.(1999;see also 1 Since,with many units, the lowestwinning bid in a uniform-priceauction is typicallynot importantly different fromthe highest losingbid, this auctionis analogousto an ascendingauction (in whichevery winnerpays the runner-up ’swillingness-to-pay). The “threats” that supportcollusion in auniform-price auctionare likewise analogous to the implicitthreats supportingcollusion in an ascendingauction. Collusionin auniform-priceauction is harder if supplyis uncertain, sincethis reducesthe numberof pointson the bidschedule that areinframarginal and can beused as threats (Klempererand Meyer, 1989;Back and Zender,1993, 1999). 172Journal of Economic Perspectives von derFehr and Harbord, 1998;Newbery, 1998; Wolfram, 1998, 1999). In addi- tion, afrequentlyrepeated auction marketsuch as that forelectricity is particularly vulnerableto collusion, because therepeated interaction among biddersexpands theset of signaling and punishment strategiesavailable to them and allowsthem to learnto cooperate (Klemperer, 2002). Much ofthe kind of behavior discussed so faris hard tochallenge legally. Indeed, tryingto outlaw it allwould require cumbersome rules that wouldrestrict bidders’ exibilityand mightgenerate inef ciencies,without being fully effective. It wouldbe much betterto solve these problems with better auction designs. Entry Deterrence and Predation Thesecond major areaof concern ofpractical auction designis to attract bidders,since an auction withtoo fewbidders risks being unpro tablefor the auctioneer(Bulow and Klemperer,1996) and potentiallyinef cient.Ascending auctions areoften particularly poor in this respect,since they can allowsome biddersto deter the entry, or depress the bidding, ofrivals. In an ascending auction, thereis a strongpresumption that the rmthat values winningthe most will be the eventual winner, because evenif it isoutbid at an early stage, itcan eventuallytop any opposition. As aresult,other rmshave little incentiveto enter the bidding and maynot do so iftheyhave evenmodest