I posted this a couple of years ago and think it’s worth reposting….
Some of you will have read The Undercover Economist by Tim Harford. It’s got some interesting pieces in it. It has a small but really interesting section in it about New Zealand. It says this:
The New Zealand government, which auctioned radio spectrum as early as 1990 with advice from some economists who seemed to have a slender grasp on reality, learned such lessons the hard way. (lessons about games not always unfolding in the way the game theorist would predict). The auctions were held without making sure that there was any interest from bidders, without minimum prices and using a theoretical curiosity called a Vickrey auction, which led to considerable embarrassment. (The auction was named after its inventor, Nobel laureate William Vickrey, who made major early advances in applying game theory to auctions.)
The Vickrey auction is a second-price sealed-bid auction. The ‘sealed bid’ means that each bidder writes down a single bid and seals it in an envelope. When the envelopes are opened, the highest bidder wins. ‘second-price’ is the curious rule that the winner pays not his bid but that of the second-highest bidder. The elegant reasoning behind this auction is that no bidder ever has an incentive to shave his bid in an effort to make more profit; making a lower bid affects his chance of winning but not the price. To a theorist, this doesn’t seem odd at all; after all, in a traditional auction at Sotheby’s or Christie’s, the price is also set by the second highest bidder, because bidding stops when the second-highest bidder drops out. To the press and many others, this Vickrey auction looked nothing short of crazy. The problem with the Vickrey auction is not substantive but stylistic; in a traditional auction nobody ever finds out the maximum price the highest bidder would have been willing to pay, but in a Vickrey auction that fact is made public. Justifiably, New Zealanders wanted to know why a bidder who had offered NZ$100,000 for a licence only had to pay NZ$6 or why one who had offered NZ$7 million was only coughing up NZ$5000. These figures were embarrassing. The theorists knew that on average, Vickrey auctions make just as much money as other auctions because, by not demanding payment of the highest bid, they encourage all bidders to offer more. But what the theorists knew did not matter to the press and to the public; the harsh reality is that Vickrey auctions were seen as a failure of the New Zealand government.
Game theory can help predict some problems, such as cheating in the US auction. Others, such as the public reaction in New Zealand, simply don’t show up in the theoretical analysis. Economists who aspire to dentistry have to think carefully and learn from mistakes,; new ones will continue to be discovered the hard way. The New Zealand government had made itself a laughing stock.
It’s an interesting story. And it’s true. So who were the key players in this unusual game?