Honesty Won This Economist a Nobel Prize

Here's the surprising math at the heart of auction theory

- JACK MURTAGH

YOU'RE AT A BLIND AUCTION, and the rules are simple: if you see something that you want, place a secret bid, and the item will sell to the highest bidder at their stated price. You would love to take home that new laptop or a concert ticket, but how much should you bid? Even if you can perfectly quantify what each item is worth to you, you face a dilemma: you have no idea how others will bid. Should you bid close to your personal maximum and risk overpaying if everybody else bids low? Or should you bid low yourself and hope to get lucky? A clever tweak to the rules of the auction eliminates this strategic guessing game and replaces it with an incentive rarely found in money games: honesty. The tweak has inspired real-world auctions that power e-commerce and helped to earn its inventor a Nobel Prize in economics.

The branch of economics known as auction theory calls the above scenario a first-price sealed-bid auction. “Sealed-bid” means bids are private, and “first-price” indicates that the winner pays the highest price among all the bids. In 1961 Columbia University professor of economics William Vickrey proposed an ingenious alternative. In his version, the highest bidder still wins but pays only the amount of the second-highest bid.

This peculiar twist has a radical effect on bidders’ incentives. In a first-price sealed-bid auction, bidders are incentivized to “shade” their bids by offering less than what they consider as the object’s true value to avoid overpaying. But in a second-price sealed-bid auction (also called a Vickrey auction), the best move would be to bid what the object is worth to you. No game playing required.