1 3720 Viewpoint Note No. 160 November 1998 Michael Klein Designing Auctions for Concessions- Guessing the Right Value to Bid and the Winner's Curse This is the third ina Once a government has decided to award a technically comparable, then the real bidding series of four Notes on concession by auction, it needs to decide what starts. In multiple rounds bidders raise their bids bidding for infrastruc- ture concessions. The kind of auction to use-whether a first-price in response to others until only one bidder, the otherthreeintheseries or second-price auction, whether sealed or winner, is left. The winner pays the last price examine how conces- open bids, and whether sequential or simulta- that he or she offered. Open auctions have been sion design affects competition in bidding neous bids for multiple items. For concessions used for radio spectrum licenses in the United and the sustainability of the standard is a first-price sealed bid auction States. the contract, whether to in which bidders submit sealed envelopes con- acinor negotiate, t nn hi fe hoig oto and the case for pe-i- taining their offer and the highest offer deter- Choosing an option odic rebidding. mines the price. The bidding may occur in one or two stages. In two-stage bidding the techni- The choice of auction method is affected by cal parameters of the bids are made compa- arguments about: rable in the first stage, and only the main offer * The political sustainability of the outcome. on the core bid parameter is submitted in the * The robustness of firms' bidding strategies. second. The main offer may relate to a price, a * The opportunities for collusion among firms. level of subsidy, a payment for net worth, or any other appropriate parameter; the discus- All these elements combine in determining sion in this Note focuses on price. In one-stage whether an auction design yields value: how bidding the entire bid is submitted,' the enve- that value is distributed among bidders, con- lopes are opened, the bids are made public, sumers, and the government; and whether the and the highest bidder wins. But it may not deal will last. immediately be obvious who has won, because bids must first be compared and evaluated on Political sustainability all relevant dimensions. These bidding approaches parallel those for civil works and Bidding for concession-type arrangements often equipment contracts. occurs among only a few players, and the price offers can differ dramatically. The winning bid In recent years debate over optimal auction has often been several hundred million dollars design has intensified. Problems with sealed bid higher than the second-highest one, as in the auctions have led to reconsideration of their Mexican railway auctions (North-east conces- merits, and new auction methods have been sion) and the Peruvian phone system privati- tried. New Zealand, for example, used second- zation. In second-price sealed bid auctions such price sealed bids to auction licenses for radio huge differences can make the result politi- spectrum. In a second-price auction the pro- cally unsustainable. The extreme outcome of cess of submitting and opening bids is like that New Zealand's radio spectrum auction, where in a first-price sealed bid auction, but the win- the first bid was NZ$100,000 and the second ner pays only the value offered by the second- only NZ$6, created obvious political problems highest bidder. In open auctions bids are made (McMillan 1994). IW |The World Bank Group * Finance, Private Sector, and Infrastructure Network Designing Auctions for Concessions-Guessing the Right Value to Bid and the Winner's Curse Open bidding processes do not reveal what the For a standard equipment contract the bidders winning bidder might have been willing to pay, often know what their own costs will be and because bidding stops when the winner offers can then calculate the best offer. But for many just a little more than the second-highest bidder. concessions bidders may need to value the right The winner thus pays more or less the second- to the concession, which depends not just on highest price, but nobody sees how much more their own skill but on factors affecting all bid- could have been obtained. That tends to reduce ders, such as consumers' willingness to pay political complications, unless the winning and regulators' future behavior. Cases where bidder's staff leaks information about how much the bid value depends only on characteristics it would have been willing to pay. of the bidder are called private value auctions. Cases where the value depends on factors that Sealed bid second-price auctions are clearly affect all bidders are called common value dangerous for political sustainability when there auctions. are only a few bidders, as is typical for conces- sions. If there were many bidders, the likeli- Different bidders have different information and hood of big differences between the first and different abilities to value a concession. So the second bids would be much lower. but the most optimistic bidder rather than the most transaction costs of the process might be pro- efficient one could win the auction, resulting hibitive. First-price sealed bid auctions and in the failure of the winner, pressures for rene- open auctions can both yield reasonable gotiation, and excessive costs. That is called sustainability, because in one case the first price the winner's curse.2 wins and in the other the first price is unknown. Bidders therefore need to assume that they are Guessing competitor strategy overoptimistic and adjust their bids downward. If they do not assume that they are the most In first-price auctions bidders need to guess optimistic bidder and discount the bid accord- how their rivals will bid. The better they guess, ingly, they will not survive for long in an in- the smaller the premium they need to bid to dustry based on common value auctions. win. If their guess is perfect, they can bid just Inexperienced bidders often fall prey to the above the second price, as in an open auction, winner's curse. and still win. Some bidders take multiple en- velopes to the bid opening. If they find that Experienced long-term players selected through they arc the only biddcr or if their most seri- prequalification to bid for concessions adjust ous competitors do not show up, they submit their bid prices conservatively so as not to fall the envelope with their lowest bid. The more prey to the winner's curse. But they might bid risk averse bidders are, the more likely that more aggressively if they had better informa- they will bid "too high" just to make sure that tion about the value of the concession. Open they win. bidding gives them some better information, because it reveals what others are willing to In second-price auctions they bid what they bid. If pessimistic bidders see that everybody think the concession is worth. They do not need is still bidding when they are thinking of quit- to think about others' valuations and can thus ting, they might continue to bid. And if bid- focus on valuing their own bid. First-price auc- ders see that most others have started to drop tions make bidding more complex for bidders, out, they would revise their valuation down- increasing the risk that clever firms rather than ward. Thus under open bidding among pru- efficient ones win. But in sealed bid first-price dent, experienced bidders the winning bid on auctions government revenue should be higher average should be higher and the likelihood than in second-price sealed bid ones if bid- of an overoptimistic bid lower. For governments ders are risk averse.' the outcome should be better and more sus- tainable deals on average. It was this expecta- While sealed bid auctions can be made some- tion that led the U.S. Federal Communications what collusion-proof, open auctions can also Commission to choose open bidding for auc- be 'proofed" a bit. For example, in an open tioning rights to radio spectrum. auction bidders' identities can be kept secret. Bidders need not be in the same room and can In general, governments should provide as bid remotely. Reputable auditors can ensure much relevant informaLion to bidders as pos- the integrity of the process. But cartels can still sible so as to make bidding more aggressive. retaliate better against defectors under open More information sometimes reveals weak- auctions than under sealed bid schemes.3 nesses in a concession proposal and thus reduces bid prices. But in such cases the win- When competition is weak, governments can ner would have had to renegotiate anyway. use reserve prices to guard against collusive low bids. Keeping reserve prices secret helps Collusion ensure that risk-averse bidders pay more rather than less. But care must be taken to prevent First-price sealed bid auctions may offer a little arbitrary manipulation of secret reserve prices better protection against collusion by bidders by corrupt auctioneers. One way is to deposit than open auctions. Suppose there is a bid- the reserve price in a sealed envelope with ding cartel among some of the bidders. In an reputable auditors. open auction they can see when one of them breaks ranks and bids more aggressively than The use of reserve prices also tends to serve agreed. Other members of the cartel can imme- political aims, by convincing the public that diately retaliate by also bidding more aggres- state assets are not sold below value. This pur- sively. Fear of such retaliation strengthens pose sometimes runs counter to sound use of discipline in the cartel. In sealed bid auctions, reserve prices. For example, when assets might however, retaliation can occur only if there is fetch less than book value, it is often politi- repeated bidding for concessions involving cally difficult to set a reserve price below book similar players. But that is often the case, par- value. But these cases are, of course, tough to ticularly for water concessions today. So in handle under any circumstances. practice sealed bid auctions may not always provide better protection against cartels than First-price sealed bid or open open auctions. auctions? Moreover, many sealed bid auctions are in real- Altogether, it is thus not quite clear whether ity open. As a result of widespread corruption first-price sealed bid auctions or open auctions bidders often learn about their competitors' bids are preferable. The private sector often uses before bid award and can adjust their own bids some form of competitive negotiation, which accordingly. Two-stage bidding offers the best in principle operates like an open auction. But safeguards against such practices. The price for government procurement or procurement envelope is submitted on the day of bid open- by regulated monopolies it is generally desir- ing, and deadlines tend to be firm. Bidders try able to allow less discretion than is involved to hand in their envelope just before the dead- in competitive negotiation. Broadly, the follow- line so as to reduce the possibility that the en- ing general arguments about the relative mer- velope will be tampered with and to take its of open and sealed bids might then hold. advantage of any information that may emerge When there is strong competition among many until the last minute. Bids are opened publicly bidders or among diverse bidders, open auc- and in the presence of auditors, who ensure tions might be preferable, because collusion is that those who open i:he bid read it out cor- unlikely, anticipating the bidding strategies of rectly and do not suppress or distort information. others is unnecessary, and the danger of the Designing Auctions for Concessions-Guessing the Right Value to Bid and the Winner's Curse winner's curse is lower. In such cases fixed ondary markets bear the burden of improving price contracts are in principle relatively more on the aggregation of concessions or licenses. desirable than cost-sharing contracts. However, first-price sealed bid auctions may be prefer- The role of the regulator in auctions able to guard against collusion when the num- ber of bidders is small. To stimulate bidding Regardless of the type of auction used, discretion competition, contracts should have higher cost will almost certainly play a part in the evalua- sharing between the concessionaire and the tion of bids. Bids may vary on so many dimen- customers. Sealed bids may also be preferable sions that nondiscretionary comparison is when bidders are risk averse and when bid- impossible. Moreover, prequalification and short- ders are diverse; under these circumstances listing may already have involved some judg- sealed bids may increase the bids placed by ment when the bidders' reputation and integrity the winner. matter, not just their verifiable track record. So it is important that the auctioneers (or panels of Simultaneous or sequential auctions? bid evaluators) be at arm's-length from political pressures and from bidders' interests. Just like In selling rights to radio spectrum the United regulators, they must be independent. States used a simultaneous open auction. Bid- ders bid simultaneously on all areas where they That said, why not have the regulator conduct wished to acquire a license to tuse a particular the auction? Since auctions are essentially a Viewpoint is an open frequency. Areas were auctioned simultaneously mechanism to improve information in price forum intended to because of the possibilities for significant review processes, the regulator seems a par- encourage dissemina- complementarities. For example, telecommuni- ticularly appropriate choice. tion of and debate on ideas, innovations, and cations firms might want to own licenses in best practices for ex- adjacent areas to reduce the costs of building ' For more technical expositions of these points see McAfee and panding the private out the infrastructure for wireless communica- 2 MeMilwan 1987 anddr-ilgrom 1989. sector. The views pub- "Lowballig" bidders-called coyotes" in Mexico-bid low in the lished are those of the tion systems. If areas are auctioned sequentially, hope of making gains later in renegotiation. If bidders expect that authors and should not bidders for one area cannot know whether they they can get away with renegotiation, they have no incentive to bid be attributed to the can acquire a valuable adjacent area and there- responsibly. For bidding to he meaningftl, failure to comply with World Bank or any of the terms of the bid must impose costs on the winnng bidder. In a its affiliated organiza- fore bid less for the first or not at all. Simulta- meaningful auction the winner's curse is a serious threat to the tions. Nor do any of the neous auctions make sense only when they are winner onficsianl represenfth open, because bidders must be able to adjust 3 This is an instance where some degree of nontransparency pre- cofilcilupsiyofs rpenthee,bcuebder utb bet adjust vents collosion. Althoogh overall, rmues to ensote transparency are World Bank or of its their bids in response to otlhers. valuable, the design of such rules needs to take such instances into Executive Directors account. or the countries they The sale of U.S. radio spectrum so far repre- represent. sents the only use of simultaneous auctions for References To order additional concession-type arrangements. For most con- McAfee, Preston I.., andJohnMcMillan. 1987. Auctions and Bidding." copies please call cessions it is not clear that such auctions offer Journal ofEconomiceiterature 25. 202-458-1111 or contact significantbenefits. Simultaneous auctionswere McMillan, John. 1994. "Selling Spectrum Rights."Journal ofEconomic Suzanne Snmith, editor, sgiiatbnft.Smlaeu utoswr metvs8 Room F6P-188, considered for the three major rail concessions Milgromr Paul. 1989. "Auctions and Bidding: A Primeri" Journal of The World Bank, in Mexico. But bidders could not aggregate con- Economic Perspectives 3. 1818 H Street, NW, Washington, D.C. 20433, cessions, because no bidder could win more or Internet address than one. Bidders simply needed to value each ssmith7@worldbank.org. concession and bid what it was worth to them. Michael Klein (Michael UKlein@SI.shell.com) available on-line A simultaneous auction might make sense for Chief Economist Shel London (www.worldbank.org/ airport slots that have to be aggregated into html/fpd/notes/). routes, because it would allow the market to @ Printed on recycled decide how to aggregate them most efficiently. paper. Once the pieces of a system are auctioned, sec-