Of gas and cell phones

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The alleged success of the British mobile phone auctions in raising revenue for the government poses many questions about the desirability of licences and auctions in general. John’s article examines the underlying logic of auctions and suggests that the current enthusiasm may be misguided

Imagine that retailers could sell next spring’s women’s fashion collections only if they had a licence. And imagine that the government limited the number of licences and put them up for auction.

The people who run shops would begin by sharpening their pencils and opening their spreadsheets. They would estimate how much they might sell next spring and how much profit they might make. And – if they had sense – they would then hire some clever economists to advise them on their bidding strategies.

But there were bigger issues at stake. How could a retailer be viable if its shops were unable to display the latest fashions? It would be making a statement to their customers that it was going out of business. All the work they had done in building up skills and expertise, in establishing their brand and their customer relationships, would be set at nought. The board would tell their executives that they had to do whatever was necessary to get one of these licences. If necessary, they would shell out the whole of the value of the business, less the likely proceeds of a closing down sale.

Now retailers might not have to pay as much as that to get a licence. What licences would in fact cost would depend on how many there were to be. If there were a lot, the price would be correspondingly low. If there were fewer licences than retailers, bidding would be ferocious. The cost of a licence would have to rise so high that some shops would conclude they would rather quit the industry than pay it.

An odd situation would arise if there were the same number of licences as retailers. Everyone would expect the licences would go to established retailers. So there would not be much point in anyone else entering the bidding. But equally there would be no need for established retailers to bid against each other. The price would not be high.

But what if there were slightly more licences than existing shops? Then it would be realistic for newcomers to try to get licences, and their expectations would set the price. The assessments of the just successful, and the just unsuccessful entrants would determine what existing retailers have to pay. Established players might well shake their heads at the unrealistic hopes of their rivals, but that would not matter: they would have to pay to stay in the game. The newcomers might feel their expectations would be confirmed by the discovery that well established retailers are willing to match their bids.

So, the auction might raise more than would be predicted from a realistic assessment of the value of next spring’s fashion collection. This would please the government, which might immediately think of holding other similar auctions. It could sell licences for men’s fashions as well – and another set of licences for the autumn collections.

At this point that the chickens come home to roost. The share prices of retailers would tumble, not only to reflect the amounts they have paid, but to reflect the amounts which they might be asked to pay in future rounds. But that would undermine the basis on which they made their bids. At the same time, retailers realise that the only way out of the trap the government had sprung would be to match the number of licences and the number of bidders. Collusion and consolidation are inevitable.

My story is not very different from what has happened in the mobile telephone business. The British and German governments pulled off an astonishing coup by taking large amounts of money from foolish investors at the height of the new economy mania. But their very success undermined the hyped valuations that had made it possible.

In the spring, the prospect of extraordinary revenues led everyone to proclaim the superiority of auctions over beauty contests. But it is very doubtful whether this is a sensible means of regulating these industries in the long run. Selling grants of monopoly was abandoned as a source of government revenue at the dawn of the industrial revolution, and for good reason. No-one – not governments, not the companies themselves, and certainly not fickle investors – has any real idea how the market for third generation mobile phone services, or similar new products, will evolve.

In these circumstances, the best government policies and corporate strategies are those which minimise risks and maintain flexibility. Large upfront payments for long term commitments do not meet these criteria.

If these new services really turn out to be bonanzas, ad hoc taxes can be used to extract revenues created by government imposed or allocated scarcities. The taxes on casinos and the lottery and the levy on independent television contractors are well established examples. The most important instance has been the development of oil and gas in the North Sea.

The offshore tax system has not been a model of simplicity or stability. But thirty years of continuing negotiation between government and the oil industry has maintained reasonable levels of company profitability and incentives to invest while ensuring that over time most of the profits from the allocation of offshore exploration rights accrue to the Exchequer. In today’s money, tax revenues from oil and gas production have exceeded the proceeds of the mobile phone auctions by a factor of ten.. If we manage the development of a new telecommunications infrastructure as well as we have managed the exploitation of the North Sea, we can be quietly satisfied.

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