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Because the price was right

Better auction design was key to ensuring that 2G spectrum did not remain unsold.

Updated: February 18, 2014 10:05:35 am
Mistakes like not setting the right reserve prices can lead to disastrous consequences as in New Zealand, where bidders paid  for licences worth 0,000. Mistakes like not setting the right reserve prices can lead to disastrous consequences as in New Zealand, where bidders paid for licences worth 0,000.

Sandip Sukhtankar

Better auction design was key to ensuring that 2G spectrum did not remain unsold
Like a good saas-bahu saga, the story of 2G spectrum allocation in India seems to have reached its end with an exciting final episode. The 2G spectrum auction has witnessed  total bids of over Rs 60,000 crore, surpassing the Rs 30,000-40,000 crore expected by the government. The auction left telecom officials relieved, particularly after the calamitous previous auctions in November 2012 and March 2013. Why has this round of auctions been successful? What lies ahead for the telecom sector?

Before answering these questions, a synopsis of the plot is in order for those casual observers who have not kept up with all the episodes in the series. It starts in early 2008, with the farcically arbitrary allocation of 122 licences (and associated spectrum) at substantially below-market rates. In 2010, following juicy plotlines involving tapped phones and corporate lobbyists, the now-famous 2G scam breaks out, with a CAG report detailing numerous irregularities in the licensing procedure. This episode also includes the arrest of then telecom minister A. Raja in early 2011. The Supreme Court annuls all 122 licences in February 2012, which leads to auctions held in November 2012 and March 2013 to allocate the spectrum afresh. Unfortunately, with the economy having taken a turn for the worse in the interim, much of the spectrum remained unsold.

The final episode involves selling this remaining spectrum, which by all accounts Trai has managed to do successfully. The main reason why the outcome of this round of auctions was different had to do with Trai getting reserve prices right. After consultation with stakeholders and considering market conditions, reserve prices were cut sharply (up to 50 per cent) compared to those in the unsuccessful previous auctions. At the time, this decision was far from universally acclaimed: many observers expressed concern over the potential loss to the government from these cuts.

One might ask: why not just increase reserve prices, and if market players do not value spectrum above these prices, they simply won’t bid? Won’t higher reserve prices lead to higher revenue for the government? The answer here is that there is no such thing as a free lunch — an increase in reserve prices may deter entrants, and in fact make it easier for remaining bidders to collude, leading to lower actual bids. To understand these ideas better, let us examine the economics behind allocating spectrum.

Radio frequency spectrum is a valuable natural resource, perhaps nowhere more so than India, where wireless telecommunication is an especially important sector of the economy. How should the government allocate this scarce resource? The allocation mechanism has two fundamental goals — to achieve allocative efficiency, that is, to ensure the most efficient use of the spectrum, and to raise revenue for the government. There is consensus amongst economists that market mechanisms — think auctions — are superior to administrative mechanisms — think Raja — in achieving these objectives.

In normal competitive auctions, there is usually no conflict between the two goals. But under conditions of natural monopoly, a small number of bidders and externalities — all characteristics of telecom markets — things get trickier. For example, the government could increase revenue collection by offering a single monopoly licence in a given region; of course, this is not good for future efficiency or consumer welfare.
Spectrum auctions are even more complicated because the underlying value of spectrum — contingent on rapidly evolving technology and changing markets — is difficult to gauge. Thus, well-understood auction problems — the winner’s curse, bidders’ risk and collusion amongst bidders — are amplified. Getting auction design right becomes paramount. Mistakes like not setting the right reserve prices can lead to disastrous consequences as in New Zealand, where bidders paid $6 for licences worth $100,000.
Fortunately, Trai got it right. Its “Recommendations on Valuation  on Reserve Price of Spectrum,” published on September 9, 2013, is a remarkable document, consisting of transparent analysis and judicious consideration of stakeholders’ concerns.
Even more commendable than simply getting the numbers right was the transparent process through which it arrived at these recommendations. It first produced a consultation paper, requesting comments from stakeholders. It then held an open discussion. All comments and documents related to the proceedings were easily available online. The data used in the analysis conducted in the recommendations report were made available, and the factors that entered the analysis clearly explained. Given the deterioration in the economy over the last 18 months, the lack of response by telecom companies in the previous auction rounds and the analysis conducted, the recommendations on reserve price cuts made sense.

The results of the current auction have justified Trai recommendations. Of course, factors other than the correct reserve prices mattered as well. For example, some telcos (Bharti Airtel, Vodafone and Idea) required spectrum in the valuable 900 MHz band just to keep existing operations going. Moreover, greater than expected demand in the Northeast, where mobile penetration is low, played a role too. But getting the fundamentals right was paramount in making sure spectrum did not remain unsold and unused.

Looking to future auctions, while Trai’s analysis in this instance was fundamentally sound, it could use more sophisticated aspects of auction theory and econometrics. For example, while the multiple regression analysis was reasonable, surely more advanced techniques could be used to calculate final numbers. In addition, the report often correctly cited the leading experts in auction theory. Why not just hire these experts to design Indian spectrum auctions in future, as the US did when it conducted its big round of spectrum auctions in  the early 1990s?

Other recommendations made in the Trai report, if adopted by the government, also stand to have a big impact on the telecom sector. Of them, the unambiguously good advice by Trai involves allowing spectrum trading. This is likely to increase efficiency in telecom markets; my previous research on the 2G scam suggested that one of the reasons the distorted allocation of licences did not affect telecom markets much was that the licences and spectrum ended up in the hands of providers likely to make efficient use of it. The suggestion to allow mergers of entities with combined market power of 50 per cent within regions is perhaps more ambiguous: while it will help with much-needed consolidation, the benefits of competition should never be underestimated. Again, my past research suggests that competitive markets may have mitigated the efficiency impact of the 2G scam.

The empowered group of ministers has already decided in favor of the M&A recommendation, while not yet reaching a decision on spectrum trading. Whatever it decides, it will do well to follow the example set forth by Trai and pursue the path of greater transparency in an effort to create the conditions and oversight necessary to let markets work.

The writer is assistant professor of economics at Dartmouth College and a visiting scholar at the Harvard Kennedy School, US

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