Wednesday, May 11, 2011

Winner's curse and market failures in resource allotments

One of the most controversial areas of public policy in recent years has been that involving allotment of public resources to private interests. As the role of the private participation in the economy expands, many hitherto public assets - land, mines, telecom spectrum, municipal infrastructure, etc - are increasingly being operated by private participants.

In light of the numerous resource allocation scandals in recent months, a debate has been generated about what is the most effective strategy to allot public resources. Though competitive allocation of resources appear to be the best strategy for such allotments, there are very valid enough reasons to be sceptical. Critics point to the need for governments to be flexible and retain discretion in such allotments in the larger public interest. Let us examine both sides and see how the balance sheet squares up.

Conventional wisdom would have it that competitive markets always result in efficient allocation of scarce resources. However, real world experience reveals that competition also has the potential to generate market failures that create inefficient outcomes. In particular, all sides in the bargain are vulnerable to the winner's curse - over-paying for your purchases. This happens irrespective of whether the allotments are done in a transparent and competitive manner or by discretionary allotments. So what is the most efficient method to allot public resources to private interests?

The most famous recent example of winner's curse is the 3G spectrum auctions in Europe at the turn of the century. Telecom operators who bid fantastic sums to claim 3G licenses soon realized the folly of their excessive commitments. It had a devastating impact on their balance sheets and adversely affected the sector itself. Subsequently, the subject has generated considerable research and analysis and many prescriptions have been offered on efficient auction designs (see Paul Klemperer here).

However, nothing seems to have been learnt from the European debacle by both policy makers and the industry itself. Though it is a little early to tell, there is enough evidence to suggest that most of the telecom operators in India over-bid during last year's 3G spectrum auctions. The poor latest quarterly results of these operators are an indicator of the strains imposed by their excessive bids.

All these represent classic market failures. It is astonishing that professionally competent managers who run these telecom operators could not have learnt the bitter lessons from the European auctions. Equally baffling is the failure of financial institutions that supported the respective bidders to exercise the required due diligence that would have exposed the risks inherent in such irrationally exuberant bidding. Policy makers too should take the blame for failing to take into account the inevitability of winner's curse in such auctions and their inability to design the auction so as to mitigate these risks.

However, one of the critical, albeit less-discussed, reasons for such exuberance in bidding could be attributed to the moral hazard arising from the increasing trend of contract re-negotiations. The number of recent precedents of governments permitting such re-negotiations on very specious and flimsy grounds, after the completion of a competitive price discovery process, has considerably eroded the sanctity of contracts. Bidders realize this and rationalize that they could bid on the higher side and mitigate any risk of winner's curse by lobbying to re-negotiate away the unpalatable terms and conditions. And when all bidders play the game on the same assumptions, then winner's curse becomes superfluous.

There is another side to the debate. Economies in transition, especially in a closely integrated world, face an interesting dilemma. On the one hand, they have to compete with others to attract investments and engender business confidence. This competition exists among nations and within them between regions. Governments therefore have to accommodate the requirements of this competitive environment and tailor policies that encourage investors. This often demands discretion-based decisions that appear to favor or provide preferential treatment to certain private groups or firms.

Consider this. A state government faces stiff competition from other states to provide additional incentives to lure say, an IT company, to prefer the state over competitors to set up its new development center. Apart from standard infrastructure sops (like assured quality of power, good connectivity etc), such incentives typically include fiscal concessions, exclusive infrastructure, and additional land. Over the past few years, states have wooed such investors with huge land allotments, far in excess of the specific investment requirements.

Arriving at the right type and degree of incentives is at best of times a very difficult exercise. There is a fundamental information asymmetry in this process. The private firm has clear information of what are the respective offers of individual states and can make its decision based on them. However, the state governments work in an environment of information asymmetry. Unaware of the promises and intentions of their competitors, a state government is forced into marking up its offer on the higher side so as to pre-empt its competitors. The private firm is fully aware of this game and contributes more than its fair share to exacerbating the information asymmetry and trying to bargain the best possible deal from its interlocutor states. The net result is that the successful government invariably ends up with a winner's curse by offering excessive concessions.

Since the environment in which these decisions have to be taken is bedevilled with information asymmetry, it is no surprise that preferential offers made to attract individual investments are mostly controversial and involve some form of corruption.

More worryingly, this challenge has to be managed by public institutions and a civil society that are rarely strong enough to exercise the vigilance required for ensuring fairness in such decisions. Most often, the public institutions are captured by the private firm and the terms of the bargain severely compromised against public interest.

The civil society and its opinion makers mistake the trees for the woods by falling prey to the attraction of a public media trial of a few scapegoats. The public debate gets circumscribed and rarely tries to address the problem with systemic solutions.

Given the prevalance of winner's curse with both strategies, how do we address the problem of public resource allotments? In an ideal world, the benevolent and wise ruler would negotiate with the best interests of his citizens at heart and commit just enough concessions to tip the investment in their favor. But as discussed, the real world is rife with information asymmetry, moral hazard, and winner's curse. Besides there are real-people (read officials and politicians) prone to colluding with unscrupulous investors and a public who are either powerless or distracted by media trials and the lure of instant justice.

Allotments of public resources by way of both competitive bidding and discretionary approaches face the problem of winner's curse. In the former, the private firms end up over-paying and ultimately ending up defaulting or atleast compromising on its commitments. In case of the latter, public resources get allotted on the cheap to private interests.

So the issue boils down to which approach is likely to work best, given these circumstances? Alternatively, which risk - winner's curse for bidders or governments - is less difficult to mitigate? Here, I am inclined to hold that ensuring transparency in the process of allotments of public resources on a discretionary mode, even through empowered committees of eminent people (who are the eminent people and how honest are they), is an almost impossible task in most developing countries, including India. Institutional mechanisms to minimize corruption is difficult to implement for a variety of reasons.

However, markets are versatile enough to mitigate the adverse consequences of winner's curse. After all, the fundamental ideological issue here is over whether the individual wisdom and knowledge of government (and a few of its officials) is superior to the collective wisdom of the market in both ensuring most efficient price discovery and in mitigating the effects of possible incentive distortions like winner's curse. This debate has been settled for some time now.

However, if markets are to determine the allotment process, it is important to structure its institutional design details by taking into account the specific issues related to the sector and lessons from failures across the world. Besides trying to resolve any winner's curse, the design should also address the other sector-specific problems that come in the way of success with such allotments. This not only ensures transparency and efficiency, it can also mitigate the consequences of the market failures that result from various incentive distortions.


VIG said...

You have rightly analysed the scenario. It is similar to a rat race. One a rat race between the state governments in order to win the prized investors, and the other a rat race between the private investors in order to get hold of some public resource. In the first case, whereas the problems of unintentional mischief like the information asymmetry etc. can be rectified with good intent, those relating to absence of integrity in the decision makers is more difficult to overcome. Similarly, the correction of any market imperfections at a post-bidding stage is much easier when compared to the correction of decision-makers' selfish motives. -- Srikant

Anonymous said...

Competetive biddings like that of 3G are rare exceptions in Indian markets and hence the incidence of winners curse shouldn't be a concern. When such transparent biddings become more common and governments abstain from contract renegotiations, the players will become more disciplined and realistic about their bids over time. Governments can sure play a positive role by utilizing the proceeds or royalties in demand stimulation exercises or investing in public infrastructure that can directly or indirectly benefit the markets.

KP said...

Dear Gulzar,

There are three distinct issues here

- One is the design of auctions to ensure that the eventual outcome is through competitive bidding ( no cartels / rigging etc)

- The second problem is one of over bidding, which represents expected returns over time - which is a question of judgement. This also represents the cost of shutting out competition.

- the third and the most difficult part is transparency and integrity, which is severely compromised. This is because the fundamental view of power seekers in our political systems is that their exercise of discretionary power is outside the purview of the law. It is this discretionary capability that makes power attractive.

Unless there are clawback provisions to recover monies and harsh penalties - dissociated from the outcomes of their actions (moral hazard) - politicians and bureaucrats hardly suffer a downside of any consequence.

Democracy and elections are hardly the mechanisms to dispense justice for what constitutes a wilful criminal compromise.

One is an issue of design, two an issue of judgement, but three is what works continuously to pervert one and two.

I think politicians and bureaucrats have come to believe that this kind of rent seeking is par for the course.


gulzar said...

"the correction of any market imperfections at a post-bidding stage is much easier when compared to the correction of decision-makers' selfish motives."

thanks srikant. that is an excellent point.

yes anon, as such contracts and bidding becomes more common, expectations will change and the moral hazard will be mitigated.

thanks KP about the reference to the 'clawback provisions' in such contracts if they are made on discretionary basis. they can be deterrent to excessively generous allotments. but, given the fact that these allotments are themselves discretionary and meant to benefit certain interests, how do we ensure that these provisions are part of the contractual obligations?

Relationship Banking said...

The stock market lost confidence, partly due to the concept that telecoms were similar to dot com (both were categorised as 'high technology' in the listings) and share prices tumbled. As they did so the ratio of debt to assets based on share price changed making the telephone operators effective credit rating look insecure.