Radio Spectrum Auctions Not Always Won By The Most Efficient Firms

Auctions of the rights to use radio spectrum may not always deliver the best outcome for society, warns research by Professor Maarten Janssen and Dr Vladimir Karamychev, published in the December 2010 issue of the Economic Journal. With the prospect of a new round of mobile telecoms auctions starting next year, their study advises on which market conditions will lead to the most efficient firms winning the licences.

In many liberalisation or privatisation processes, governments eventually face the issue of how to select firms that will provide the formerly publicly provided service. One of the advantages of using auctions as a selection mechanism, so it is often thought, is that auctions select the most cost-efficient firms. The selection of efficient firms is good from the point of view of society as a whole since markets where active firms are cost-efficient typically yield the most efficient market outcomes.

An important market where auctions have been heavily used is the mobile telecommunications industry. Radio spectrum has been auctioned by authorities in the UK and many other countries around the globe since the mid-1990s. As licences for spectrum use typically last for between 12 and 20 years, and as new spectrum bands become available (the 800MHz frequencies, known as the ”digital dividend”, but also 2.6 GHz frequencies), a new round of mobile telecoms auctions is scheduled from 2011.

Many regulators have argued for the use of auctions in this context to guarantee the selection of the most efficient firms. This study argues that auctions may select efficient firms but they do not always do so. The research describes market conditions where the selection of efficient firms is guaranteed and where it is not guaranteed.

In a monopoly context, where the regulator auctions off just one licence, the most cost-efficient firm will always win the auction. The main reason for this is that for given market conditions a firm with the lowest costs expects to make the highest profits, and therefore is also willing to make the highest bid in the auction and thus wins.

In a monopoly context, the most cost-efficient firm sets the lowest market price and therefore produces the service in such a way that it generates the highest welfare for consumers.

In the case of mobile telecoms markets, however, governments have relied on a combination of ”competition for” and ”competition in” the market. Competition in the market guarantees that the inefficiency of the market allocation due to the possible existence of market power is as small as possible. This is achieved by auction designs that stipulate that not all spectrum frequencies up for sale can be won by one firm.

Competition for the market guarantees that the government receives a financial return for the licences that is in line with their value. Efficient assignment of frequency spectrum implies that the most cost-efficient firms should win the available licences. But this study argues that when there are multiple licences awarded to multiple firms, auctions may not select the most cost-efficient firms.

The reason why the monopoly result does not carry over to the case where multiple licences are auctioned is that there is a strategic effect in oligopoly markets. The strategic effect originates from the fact that a firm”s profit in an oligopoly market depends on the cost-efficiency of all other competitors. Firms prefer not to compete with other cost-efficient firms as this will lower their profits.

Depending on the market conditions and the cost structure of the industry, the strategic effect can be so strong that auctions actually do not select the most efficient firms. The researchers show that this is more likely to happen when marginal cost is more responsive than average cost to the difference in efficiency between the firms.

”Do Auctions Select Efficient Firms?” by Maarten Janssen and Vladimir Karamychev is published in the December 2010 issue of the Economic Journal.

Maarten Janssen

University of Vienna | marten/janssen@univie.ac.at

Vladimir Karamychev

Erasmus University, Rotterdam | +31-(10)-408-2158 | karamychev@ese.eur.nl