Beauty and the bidder

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Should scarce assets be allocated by auction to the highest bidder or by a beauty contest of suitable applicants? From FIFA’s decision on where to hold the World Cup to the ways in which European governments assign mobile phone licences, the choice of process is the economic issue of the moment.

It is the most basic problem of economics: how to allocate a valuable asset in strictly limited supply. The opportunity to host the World Cup in 2006. A franchise to run the National Lottery for five years. Ownership of Van Gogh’s “Portrait of Dr Gachet”, which achieved $82.5m (£54.2 m), the highest price ever paid at auction for a painting.. Control of the diamond mines of Sierra Leone. A licence to build a mobile phone network. In such situations both the economics and the politics invariably prove difficult.

There are two basic ways to resolve the issue. One is the beauty contest. Contestants parade their charms and a panel of judges picks the winner. The other is the auction, where the item is sold to the highest bidder.

There are also hybrids. The lottery franchise is a legitimate hybrid – the winner will be chosen partly on the basis of competence and integrity, partly by reference to what can be raised for good causes. The war in Sierra Leone is an illegitimate hybrid. Money, popularity and intimidation are all relevant to the outcome. And the distribution of international sporting events seems to be another illegitimate hybrid. It is meant to be a beauty contest, but looks more like an auction.

Economists tend to favour auctions, believing in the universal balm of market forces. Politicians like beauty contests, which provide maximum discretion. But things are rarely so simple. The auction of Portrait of Dr Gachet put the painting in the hands of Ryoei Saito, a Japanese paper magnate. He stored it in a bank vault until his estate disposed of it for a much lower price. It is hard to argue that this was a good solution to the problem of allocating that scarce resource between competing ends.

Nor does the result of the mobile phone auction lend conviction to the argument that an auction necessarily selects the most suitable applicant. Commercial auctions suffer from the winner’s curse: the successful bidder may be the most irrationally exuberant rather than the best qualified.

Still, the auction raised a great deal of money for the British government. And money is always central.

The opportunity for either auctions or beauty contests generally arises when an asset is valuable and in limited supply. That establishes economic rents, which everyone wants. It is very difficult to keep such processes honest. Even in Britain, with an unusually long tradition of incorruptible government, the record is patchy.

The lottery franchise or the allocation of offshore oil rights seem to have worked reasonably well, but the award of planning permission and the funding of political parties are less satisfactory.

Other countries encounter greater difficulties. And the allocation of international sporting events, like the Olympics or the World Cup, entails a clash between different national cultures. Poor Charles Dempsey, from honest but distant New Zealand, broke under the strain.

This problem that has no simple answer. But there are two key questions for those who have to find one. First, are the returns to the winner basically commercial, or largely psychological? In other words is the principal reward financial or is it the prestige the winner accrues? Offshore oil auctions fall into the first category while the title of European City of Culture comes into the second. Second, is there a substantial public interest at stake beyond the amount of revenue that the asset raises? With offshore oil, the government’s only important concern is to extract as much money as possible. When a local authority grants planning consent, however, it is not solely interested in seeing the asset put to its most valuable use.

If there are only financial returns, and no other public interest issues, the choice is between a beauty contest – accompanied by a tax structure that will extract most of the revenues – and an auction. Natural resource industries have usually followed the first, while communications increasingly uses the second.

The auction seems at first sight to expose the government to less risk and to hold out the prospect of greater returns. But there is not yet much evidence to show that these advantages materialise. The results of allocating television franchises, and of contracting out local authority services, give cause for doubt. When weak applicants have paid too much, or circumstances differ from those envisaged when the contract was signed, the terms agreed are renegotiated. And so the apparent fairness and certainty of the auction mechanism prove illusory.

The larger the non-monetary proportion of the reward the less attractive the auction. Private bodies can sometimes auction non-financial benefits – the stadium can be named after the most generous sponsor, the richest supporter can be appointed chairman of the club. Universities can – just about – get away with conferring their grandest titles on their most generous benefactors. But public authorities can rarely get away with such processes. To sell the title of City of Culture to the highest bidder destroys the value of the honour you confer.

The introduction of public interest issues beyond money makes the use of a beauty contest inevitable. Still, there are ways to reduce embarrassment. Ensure, as far as possible, that the pecuniary benefits of success are taxed away, and are taxed away on a basis common to all participants. Otherwise that money is available to corrupt the process, and it will do so. Have the contest managed with defined criteria and in an objective, judicial way, as far-removed from political processes as possible. If FIFA had followed these principles, it might not be in the disrepute it is today.

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