By the early 1990s economists had used game theory to analyze bidding strategies for a wide range of situations, including hundred-million-dollar oil lease auctions. But the idea of using game theory to design the rules of the auction itself remained very much theoretical science. In 1993 that suddenly changed.
In August of that year the U.S. Congress told the Federal Communications Commission to experiment with auctioning spectrum licenses for wireless communications services. The FCC’s previous method of distributing licenses–just giving them away–had long been a bone of contention.
In the early days of spectrum licensing, the FCC had decided which firms should get licenses by holding hearings. But by the early 1980s so many firms were applying for licenses that the system ground to a halt. In 1982 the FCC decided to start awarding licenses by lottery, figuring that telecommunications companies could sort things out afterwards by selling each other licenses. But the FCC didn’t put any restrictions on who could participate in the lotteries, with embarrassing and outrageous consequences: One year, for instance, a group of dentists won a license to run cellular phones on Cape Cod, then promptly sold it to Southwestern Bell for $41 million. Even worse, it took telecommunications companies years to shuffle and reshuffle the licenses into the right hands, which is one of the reasons that Europe got cell phone service so much sooner than the United States.
Congress wanted an easy method to assign the licenses directly to the companies that would use them best. And having witnessed the sums of money companies were paying one another for the licenses, it wanted a share of the loot. Auctions, which tend to award the prize to the bidder who values it most and to extract a lot of money along the way, seemed like the way to go.
In October 1993 the FCC invited the telecommunications industry to submit proposals for how to structure the auction, publishing a preliminary report that contained footnotes to many of the important papers of auction theory. Telecom companies, most of which knew little or nothing about auction theory, started scooping up the authors of the papers as consultants. Auction theorists were suddenly a hot commodity.
The FCC had more than 2,500 licenses to disperse. Traditionally, when many items are up for auction, auctioneers sell them one at a time. But spectrum licenses, unlike rare coins or paintings, are not independent of each other: One company might want a northern California license only if it can also get a southern California license, for instance. If the licenses were auctioned one at a time, with the northern California license coming up first, a company that wanted both wouldn’t know how high to value the northern license, since it wouldn't know what its chances were of getting the southern license later. This would create the risk that some licenses would fail to be won by the bidders who needed them most. And because bidders would have such incomplete information about the value of the licenses, they would bid cautiously to avoid the winner's curse. On the advice of game theorists the FCC decided to auction the licenses in one fell swoop, in spite of the challenges of running such a complicated auction.
The FCC also had to decide which auction type to use: sealed or open bids, first price or second? Milgrom and Weber’s research suggested that an open English auction would raise the most revenue, since it would allow bidders to gather the most information and make them bid most confidently. The FCC decided to follow that advice, with a slight twist: In each round of the auction the bidders placed bids secretly in enclosed booths; the FCC then announced the new high price without saying who had bid it. Masking the bidders’ identities in this way lessened their ability to engage in retaliatory bidding against each other or in collusion to keep prices down.
The final design, based on proposals by Milgrom, Wilson, and auction theorist Preston McAfee of the University of Texas, Austin, was a spectacular success. Not only did it raise more money than anyone anticipated but it also succeeded in Congress’s primary goal: to award the licenses to companies that would use them efficiently. Within two years of the first spectrum auctions, wireless phones based on the new technology were on the market.
