The Federal Communications Commission recently proposed a voluntary “incentive auction” of most of the nation’s over-the-air television frequencies.  The process of trading rabbit ears for smartphones begins with a reverse auction for the broadcasters’ spectrum.  The auction is called a “reverse” auction because the government is buying, not selling, the spectrum used by the broadcasters.  The auction may have another innovative feature: unlike ascending bid auctions such as those on eBay, the FCC will start with very high prices for broadcast stations and then lower the prices broadcasters can receive as the auction progresses.  The descending prices will prompt some broadcasters to quit the auction and continue broadcasting instead.  Others will remain in the auction until the FCC finds a point at which the amount of spectrum broadcasters surrender matches the demand a more traditional ascending auction identifies for new broadband frequencies. 

The goal is simple in concept but challenging in practice: the FCC must reallocate the least valuable TV Broadcast licenses to the most valued wireless broadband uses.

Designed properly, the voluntary incentive auction should ensure that spectrum is reallocated only when the new uses are more valuable than the old ones.  Trouble occurs when the auction rules encourage participating bidders to bid less than truthfully.  By way of example, imagine two homeowners selling homes of different value to a developer.  The developer has a budget of $300,000 and values both properties equally.  Homeowner A would sell a home for $200,000, and homeowner B would sell a home for $100,000.  When listing the homes, however, both homeowners ask the same list price, $200,000.  Suppose the developer buys Home A for $200,000.  The outcome is not horrible: Homeowner A, who bid truthfully, sells her home, but Homeowner B, who bid untruthfully, does not.  But the results could have been better.  The developer could have purchased both homes for $300,000.  Truthful bidding would have helped everyone concerned.

This example illustrates that the most economically efficient auction is one where every participant’s best, profit-maximizing choice is to bid exactly what the object is worth to that bidder.  In the case of the broadcast incentive auction, the FCC seeks to create a structure that encourages and rewards this type of truthful bidding.   If the auction creates incentives for broadcasters to demand either too much, or too little, revenue from a sale, everyone loses.  For example, if some bidders demand prices higher than their perceived value of the license, less valuable broadcasters may remain on the air while more valuable broadcasters are removed.  Similarly, if the auction were to set winning prices lower than the broadcaster’s subjective value of the license, broadcasters will not participate, resulting in less spectrum available for higher-value broadband.  Therefore, a key challenge for the FCC is to design an auction that both (a) minimizes bidder incentives to bid more than they are willing to accept and (b) provides ample assurance that incumbents will never have to sell at less than the value that they place on the license.

Bidders are more likely to bid truthfully when they have assurance that the price they receive if their bid is accepted is independent of, and at least as high, as their bid.  When broadcasters expect to receive higher payments, regardless of their bids, they have a greater incentive to bid truthfully.  Conversely, if bidders expect to receive little more than what they bid, they may try to bid more than their true value.  Under threshold pricing, or second-price auction rules, a winning bidder receives the lowest bid not accepted, ensuring that accepted bidders receive the market clearing price, regardless of their own bid.  Bidders have the incentive to declare their true value, because it has no bearing on their payment if accepted.

In the incentive auction notice, the FCC has proposed adopting one of two possible procedures for collecting bids: a single-round, sealed-bid auction in which broadcasters submit a single bid for going off the air; and a multiple-round, descending clock auction in which broadcasters stay in the auction until the clearing price falls below a price they are willing to accept.  Under the multiple-round, descending-clock auction, the winning bid will be equal to the prevailing price when the last bidder dropped out of the auction, e.g., the threshold price.  In the case of a single-round, sealed-bid option, the FCC has not stated whether it would pay the actual or threshold bid price.

It is difficult to tell whether one approach will unambiguously transfer more money to the broadcasters than the other.  This outcome will ultimately depend on yet-to-be determined details of each proposed approach.  The descending-clock approach would probably lead to higher prices, but only if prices are uniform across a market.  However, the FCC is considering station-specific descending-clock prices, which could result in very low prices for some broadcasters that are not pivotal to clearing a market.  While efficient, the descending-clock auction will likely complicate auction administration and, at the margins, may discourage some broadcasters from selling their spectrum.  Ultimately, the FCC will have to balance the conflicting objectives of creating incentives for broadcasters to bid truthfully against not unnecessarily overpaying broadcasters for their licenses.  While the balance remains open to debate, the enormous consumer gains from wireless broadband combined with the relative inefficiency of over-the-air broadcasting as a video-delivery mechanism suggest that ensuring efficient spectrum reallocation may prove more critical than concerns about theoretical overpayments to broadcasters.

The FCC has asked for comments on which approach is more likely to encourage participation by broadcasters.  Broadcasters, broadband providers, and other stakeholders interested in a successful auction should consider which of these procedures – single-round, sealed bidding or descending clock auction – will evoke greater participation and more truthful bidding by broadcasters.  Comments in response to the Notice are due January 25, 2013 and replies are due March 12, 2013.

Coleman Bazelon & Giulia McHenry