In July 1994 in the ballroom of the Omni Shoreham Hotel in Washington, D.C., a most unusual auction was in progress. No famous paintings, valuable coins, or antique furniture sat on the auction block. For sale was nothing but air: a slice of the electromagnetic spectrum for a new generation of cell phones, pagers, and other wireless communication devices. The U.S. government had never auctioned anything so valuable before, and no one knew just what was going to happen. The Federal Communications Commission (FCC) estimated that the airwave spectrum was worth about $10 billion, but telecommunications industry leaders scoffed at the idea that they would pay anywhere near that sum.
Once bidding launched, however, prices started rising tens of millions of dollars by the hour, to telecom executives’ disbelief and horror. “It felt as if we were playing multi-million-dollar games of poker,” recalls John McMillan, an auction theorist at Stanford University, who helped the FCC run the auction.
That first auction garnered $617 million for just 10 small licenses, and another held in December of that year raised more than $7 billion, breaking all records for the sale of public goods in America and leading the New York Times to hail it as “the greatest auction ever.” By early 2001 the spectrum auctions had brought in $42 billion, with more licenses still to be sold.
But things could have turned out differently. To make sure the auctions would go smoothly the government invested a lot of effort in preparing the rules of the auctions, and it paid off.
Designing the auction rules was a problem of great complexity. The FCC had divided the spectrum into thousands of licenses. Should it auction them all at once or one at a time? Should it use an open bidding format or collect sealed bids? Could it choose rules that would ensure that the licenses went to firms that would use them quickly and efficiently? Could it avoid loopholes firms could exploit, as well as prevent companies from colluding with each other to keep prices low?
To attack these questions the FCC turned to experts in the mathematical field of game theory, which figures out which strategies work best in a competitive situation. Over the decades economists had used game theory to develop a detailed picture of how bidders would behave in different types of auctions. Now the theoretical picture was put to the test, and it passed with flying colors.
The U.S. spectrum auctions have been imitated globally to sell a wide range of goods and services, including electric power, timber, and even pollution reduction contracts. Most of these auctions have been great successes. A few, in which the designers failed to heed the lessons of game theory, have been dismal flops.
The founders of game theory could never have dreamed that by the end of 2001, auctions designed using the principles of game theory would have raised more than $100 billion worldwide. Game theory, which started out in the 1920s as basic research into strategies of such parlor games as poker, has become very big business indeed. (1)
