Paul R. Milgrom

Wilson took Milgrom on as a mentee and fast forward to today, both of the students and their professor alike are all Nobel Laureates in Economic Sciences.

Working Amongst Giants

From 1979 to 1983 Milgrom taught at the Kellogg School of Management at Northwestern University. His colleagues included his old classmate Holmström along with Roger Myerson and Nancy Stokey. Game theory was just taking off as a part of economics and collectively they were conducting new research, competing with each other, and making suggestions.

“We had no clue about how important the whole package of work was going to be,” says Milgrom. “We felt good about what we were doing, but we didn't know that economic theory from before that era was basically going to vanish and that everything would be based on game theory models.”

The intellectual excitement and sense of community is something Milgrom remembers vividly today.

“We were told that on average, half the people here will get tenure,” he laughs. “They didn't say half of us were going to win Nobel Prizes, which is the way it actually turned out.”

Better Mechanisms Through Game Theory and Market Design

Milgrom and his colleagues were challenging traditional economic theories and looking to redesign markets, structures, and the tools used by economists.

“Game theory provided a tool that we could use to analyze very specific rules that say, you make a bid, he makes a bid, she makes a bid,” he says. “How do we put these bids together to determine prices for the various items? So we used game theory in the early days to analyze bargaining rules, auction rules and other processes, entry decisions, things that didn't fit naturally in traditional economics from 100 years ago.”

Despite being a new branch of the field, game theory quickly became very powerful and new branches started out from under it, including mechanism design and market design.

“The question of mechanism design was if we understand how people play, given the rules of the game, maybe we can design the rules of the game to improve the outcomes,” says Milgrom. “That’s what mechanism design is all about, trying to create better mechanisms and then using game theory to predict how those mechanisms will perform.”

“Market design uses mechanism design in a practical way when the models that we have are not all that's going on in the world,” he continues. “Our models are simplifications. We need to create things that will work in the real world, and we need to take into account many more things than traditionally go into mechanism design, whereas market design is designing all the practical rules that make for something that works in the real world.”

Mechanism design is about trying to create better mechanisms and then using game theory to predict how those mechanisms will perform.

A Charity Inspired Auction Theory

Milgrom and Wilson were approached in the 1980s by the Federal Communications Commission (FCC). Congress had authorized the FCC to move to a bidding system to allocate cell phone spectrum licenses, something they had not yet done, and were looking for proposals as to how the bidding structure could be implemented.

Before this request came in, Milgrom had been inspired by a charity auction held at one of his children’s schools. The set up was typical. There were tables that had a variety of items that had been donated and were for sale. Next to each item was a sign-up sheet where parents could write their name and place a bid.

“I noticed that some people were just walking around doing nothing,” says Wilson. “And then at the end, they would walk up just before the bell rang and finally put in their bid. And they’d win the items. This was an auction where the bidders could game the system by waiting until the end and then putting in their bids without anybody getting an opportunity to respond.”

Dozens of companies were looking to augment their local wireline through the cell phone licenses bidding auction and Milgrom wanted to prevent what he had seen in real time at the charity auction from being replicated at the FCC.

“The proposal that Bob [Wilson] and I made said everything is for sale at once, but it's going to go in a series of rounds and if you don't bid in some round, then you're not eligible to bid in the next round either. You can't wait till the end,” says Milgrom. “And then we had what we called an activity rule that said you can't increase bidding activity during the course of the auction. That was a huge innovation.”

“We called it a simultaneous multiple round auction, and the rounds let us keep track of the activity,” he continues. “That activity rule together with a rule that says the auction doesn't end until there are no new bids ensure that, at least in the context of the first auction, that competition worked effectively.”

Their proposal was accepted by the FCC and copied widely around the world.

We had what we called an activity rule that said you can't increase bidding activity during the course of the auction. That was a huge innovation.

A Boutique Approach to Sustainable Auctions

After the success of the FCC incentive auction design, Milgrom was approached by so many firms looking to explore their own bidding options that he co-founded, an auction and consulting firm.

“We call it the high stakes auction company,” he says. “Almost all the auctions that we're involved in are at least a billion dollars or bigger. We either advise those who are designing the auction to run the auction well for whatever their objectives may be, or we advise bidders on how to bid effectively in the auction to try to get what they want without overpaying. We take account of the winner's curse, competition, and any complexities that exist in the auction.”

He also used this environment to explore new markets due, in his mind, for a redesign. His latest focus is on creating new kinds of markets for water rights, focusing specifically on surface water in California.

“Water rights were determined historically in California,” says Milgrom. “If you set up a farm, you got rights to take water from there and you had priority over people who came later. It was very convenient in the early history but those kinds of rights are very hard to transfer. Now we have high values uses. Moving the water from its old less valuable use into a higher value use is made hard.”

“Creating the new uses requires some market design,” he continues. “We have to create markets where there were none before because the prerequisites for markets didn't exist. And that's what I'm trying to do.”

Milgrom is hopeful that now that he has been awarded his field’s highest honor, that more influence within political circles may follow as well.

“Everybody knows we need new water market designs,” he says. “I believe if I can make a good proposal and approach the Governor of California and say I have a solution to this problem, I think I can get heard. And so that's the way I want to use this.”

Good economics research will help us adapt better to climate change. It will help us with problems of income inequality, with international trade, and with refugees.

Greener Economics to Benefit us All

Milgrom hopes that his work on reforming water rights extends beyond California, that a proposal generalizable enough can be implemented and that other jurisdictions in the world can copy it to help solve water problems resulting from climate change.

“Economics starts by asking questions about resource allocation. That is, how do we make the best use of the limited resources we have,” says Milgrom. “How do we live within the constraints that face us? And I think that good economics research will help us adapt better to climate change. It will help us with problems of income inequality, with transitions to ease the cost of transitions as changes are inevitably made, dealing with international trade, and refugees.”

“Economics focuses on how we take advantage of individual capabilities and individual knowledge,” he says. “You've got to enlist the cooperation of people all around the world or all around your community to try and solve problems. And I feel like this would be a great project to finish my career with.”