Undesirable Incentives in the Incentive Auction (w. Emily Schaal)

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Following the 2016 U.S. Presidential election, in a letter to FCC Chairman Wheeler, Republicans urged the FCC to avoid “controversial items” during the presidential transition.  Shortly thereafter, the Commission largely scrubbed its Nov. 17 agenda resulting in perhaps the shortest Open Commission Meeting in recent history.  Start at 9:30 here for some stern words from Chairman Wheeler in response.  Viewers are urged to pay particular attention to an important history and civics lesson from the Chairman in response to a question at 17:20 (though this should not indicate our agreement with everything that the Chairman says).

So what is the Commission to do prior to the transition?  According to the Senate Committee on Commerce, Science, and Transportation, the FCC can “focus its energies” on “many consensus and administrative matters.”  Presumably, this includes the FCC’s ongoing incentive auction, now set for its fourth round of bidding, and subject to its own controversies, with dissenting votes on major items released in 2014 (auction rules and policies regarding mobile spectrum) by Republican Commissioners concerned about FCC bidding restrictions and “market manipulation,” along with a statement by a Democratic Commissioner saying that FCC bidding restrictions did not go far enough.

The Incentive Auction

Initially described in the 2010 National Broadband Plan, the Incentive Auction is one of the ways in which the FCC is attempting to meet modern day demands for video and broadband services.  The FCC describes the auction for a broad audience in some detail here and here.  In short, the auction was intended to repurpose up to 126 megahertz of TV band spectrum, primarily in the 600 MHz band, for “flexible use” such as that relied on by mobile wireless providers to offer wireless broadband.  The auction consists of two separate but interdependent auctions—a reverse auction used to determine the price at which broadcasters will voluntarily relinquish their spectrum usage rights and a forward auction used to determine the price companies are willing to pay for the flexible use wireless licenses.

Repackaging

What makes this auction particularly complicated is a “repackaging” process that connects the reverse and forward auction.  The current licenses held by broadcast television stations are not necessarily suitable for the type of contiguous blocks of spectrum that are necessary to set up and expand regional or nationwide mobile wireless networks.  As such, repackaging involves reorganizing and assigning channels to the remaining broadcast television stations—that remain operational post-auction—in order to clear spectrum for flexible use.

The economics and technical complexities underlying this auction are well described in a recent working paper entitled “Ownership Concentration and Strategic Supply Reduction,” by Ulrich Doraszelski, Katja Seim, Michael Sinkinson, and Peichun Wang (henceforth Doraszelski et al. 2016) now making its way through major economic conferences (Searle, AEA).  As the authors point out with regard to the repackaging process (p. 6):

[It] is visually similar to defragmenting a hard drive on a personal computer.  However, it is far more complex because many pairs of TV stations cannot be located on adjacent channels, even across markets, without causing unacceptable levels of interference.  As a result, the repackaging process is global in nature in that it ties together all local media markets.

With regard to the reverse auction, Doraszelski et al. (2016) note that (p. 7):

[T]he auction uses a descending clock to determine the cost of acquiring a set of licenses that would allow the repacking process to meet the clearing target.  There are many different feasible sets of licenses that could be surrendered to meet a particular clearing target given the complex interference patterns between stations; the reverse auction is intended to identify the low-cost set . . . if any remaining license can no longer be repacked, the price it sees is “frozen” and it is provisionally winning, in that the FCC will accept its bid to surrender its license.

The idea is that the FCC should minimize the total cost of licenses sold on the reverse auction while making sure that its nationwide clearing target is satisfied.  As Doraszelski et al. (2016) note, the incentive auction has various desirable properties.  Of particular note is strategy proofness (see Milgrom and Segal 2015), whereby it is (weakly) optimal for broadcast license owners to truthfully reveal each station’s value as a going concern in the event that TV licenses are separately owned.

Strategic Supply Reduction

However, the author’s main concern in their working paper is that in spite of strategy proofness, the auction rules do not prevent firms that own multiple broadcast TV licenses from potentially engaging in strategic supply reduction.  As Doraszelski et al. (2016) show, this can lead to some fairly controversial consequences in the reverse auction that might compound any issues that could arise (e.g., decreased revenue) due to bidding restrictions in the forward auction.  Specifically, the authors find that multi-license holders are able to earn large rents from a supply reduction strategy where they strategically withhold some of their licenses from the auction to drive up the closing price for the remaining licenses they own.

The incentive auction aside, strategic supply reduction is a fairly common phenomenon in standard economic models of competition.  Consider for instance a typical model of differentiated product competition (or the Cournot model of homogenous product competition).  In each of these frameworks, firms’ best response strategies lead them to set prices or quantities such that the quantity sold is below the “perfectly competitive” level and prices are above marginal cost—thus, firms individually find it optimal to keep quantity low to make themselves (and consequently, their competitors) better off than under perfect competition.

In the incentive auction, a multi-license holder that withdraws a license from the auction could similarly increase the price for the remaining broadcast TV licenses that it owns (as well as the price of other broadcast TV license owners).  However, in contrast to the aforementioned economic models, in which firms effectively reduce supply by underproducing, a firm engaging in strategic supply reduction is left with a TV station that it might have otherwise sold in the auction.  The firm is OK with this if the gain from raising the closing price for other stations exceeds the loss from continuing to own a TV station instead of selling it into the auction.


Example 1

Consider the following highly stylized example of strategic supply reduction: There are two broadcasters, B1 and B2, in a market where the FCC needs to clear three stations (the reverse auction clearing target) and there are three different license “qualities,” A, B, and C, for which broadcasters have different reservation prices and holdings as follows:

B1 Quantity B2 Quantity Reservation Price
A 1 2 10
B 1 0 6
C 2 1 2

Suppose that the auctioneer does not distinguish between differences in licenses (this is a tremendous simplification relative to the real world).  Consider a reverse descending clock auction in which the auctioneer lowers its price in decrements of $2 starting at $10 (so $10 at time 1, $8 at time 2, and so on until the auction ends), and ceases to lower its price as soon as it realizes that any additional licensee drop outs would not permit it to clear its desired number of stations (as would for instance happen when quality A and B licenses drop out).  Suppose that a broadcaster playing “truthfully” that is indifferent between selling its quality license and dropping out remains in the auction (so that for instance, A quality licenses are not withdrawn until the price falls from $10 to $8).

In a reverse descending clock auction in which broadcasters play “naïve” strategies, each broadcaster would offer all of their licenses and drop some from consideration as the price decreases over time. However, there is another “strategic” option, in which B1 withholds a quality C license from the auction (B1 can do so by either overstating its reservation price for this license—say claiming that it is $10—or by not including it in the auction to begin with):

Naive Strategic
B1 B2 B1 B1 B2
Offered Offered Offered Withheld Offered
A 1 2 1 2
B 1 1
C 2 1 1 1 1
Licenses Auctioned 7 6

The results of the naïve bidding versus the strategic bidding auction are quite different.  In the naïve bidding auction, the auctioneer can continue to lower its price down to $4 at which point B1 pulls out its B quality license and the auction is frozen (further drop outs would not permit the desired number of licenses to be cleared).  Each broadcaster earns $4 for each quality C license with B1 earning a profit of 2×($4-$2)=$4.

Suppose instead that broadcaster B1 withheld one quality C license.  Then the auction would stop at $8 (because there are only three licenses left as soon as A quality licenses are withdrawn).  Each broadcaster now earns $8 per license sold, with B1 earning a profit of ($8-$6)+($8-$2)=$8.  Moreover, B2 benefits from B1’s withholding, earning profit of $6 instead of $2, as in the naïve bidding case.  The astute reader will notice that B1 could have done even better by withholding its B quality license instead!  This is a result of our assumption that the auctioneer treats all cleared licenses equally, which is not true in the actual incentive auction.  Finally, notice that even though B2 owns three licenses in this example, strategic withholding could not have helped it more than B1’s strategic withholding did unless it colluded with B1 (this entails B2 to withhold its quality A licenses and B1 to withhold both quality C licenses).


Evidence of Strategic Supply Reduction

Doraszelski et al. (2016) explain that certain types of geographic markets and broadcast licenses are more suitable for strategic supply reduction.  They write:

First, ideal markets from a supply reduction perspective are [those] in which the FCC intends to acquire a positive number of broadcast licenses and that have relatively steep supply curves around the expected demand level.  This maximizes the impact of withholding a license from the auction on the closing price . . .  Second, suitable groups of licenses consist of sets of relatively low value licenses, some with higher broadcast volume to sell into the auction and some with lower broadcast volume to withhold.

What is perhaps disconcerting is the fact that Doraszelski et al. (2016) have found evidence indicating that certain private equity firms spent millions acquiring TV licenses primarily from failing or insolvent stations in distress, often covering the same market and in most instances on the peripheries of major markets along the U.S. coasts.  Consistent with their model, the authors found that many of the stations acquired had high broadcast volume and low valuations.

Upon performing more in depth analysis that attempts to simulate the reverse auction using ownership data on the universe of broadcast TV stations together with FCC data files related to repacking—the rather interesting details of which we would encourage our audience to read— Doraszelski et al. (2016) conclude that strategic supply reduction is highly profitable.  In particular, using fairly conservative tractability assumptions, the authors found that simulated total payouts increased from $17 billion under naïve bidding to $20.7 billion with strategic supply reduction, with much of that gain occurring in markets in which private equity firms were active.


Example 2

Suppose that in our example above that the quality C stations held by broadcaster B1 were initially under the control of two separate entities, call these B3 and B4.  Then, if B1, B2, B3, and B4 were to participate in the auction, strategic withholding on the part of B1 would no longer benefit it.  However, B1 could make itself better off by purchasing one, or potentially both of the individual C quality licenses held by B3 and B4.  Consider the scenario where B1 offers to buy B3’s license.  B3 is willing to sell at $4 or more, the amount it will earn under naïve bidding in the auction and Bertrand style competition between B3 and B4 will keep B1 from offering more than that.  With a single C quality license, B1 can proceed to withhold either its B or C quality license, raise the price to $8, and benefit both itself, and the other broadcasters who make a sale in the auction.


This result, whether realized by the FCC ex-ante or not, is problematic for several reasons.  First, it raises the prospect that revenues raised in the forward auction will not be sufficient to meet payout requirements in the reverse auction.  As is, this has already occurred three times, with the FCC having had lowered its clearance target to 84 megahertz from the initial 126 megahertz; though we caution that the FCC is currently not permitted to release data regarding the prices at which different broadcasters drop out of the auction, so we cannot verify whether final prices in earlier stages of the reverse auction were impacted by strategic supply reduction.  Second, as is the case with standard oligopoly models, strategic supply reduction is beneficial for sellers, but not so for buyers or consumers.

Third, strategic supply reduction by private equity firms raises questions about the proper role and regulation of such firms.  The existence of such firms is generally justified by their role in providing liquidity to asset markets.  However, strategic supply reduction seems to contradict this role, particularly so if withheld stations are not put to good use—something Doraszelski et al. (2016) don’t deliberate on.  Moreover, strategic supply reduction relies on what antitrust agencies often term as unilateral effects—that is, supply reduction is individually optimal and does not rely on explicit or tacit collusion.  However, whereas antitrust laws are intended to deal with cases of monopolization and collusion, it does not seem to us that they can easily mitigate strategic supply reduction.

Doraszelski et al. (2016) propose a partial remedy that does not rely on the antitrust laws: require multi-license owners to withdraw licenses in order of broadcast volume from highest to lowest.  Their simulations show that this leads to a substantial reduction in payouts from strategic bidding (and a glance at Example 1 suggests that it would be effective in preventing strategic supply reduction there as well).  Although this suggestion has unfortunately come too late for the FCC’s Incentive Auction we hope (as surely do the authors) that it will inform future auctions abroad hoping to learn from the U.S. experience.

This post was written in collaboration with Emily Schaal, a student at The College of William and Mary who is pursuing work in mathematics and economics.  Emily and I previously worked together at the Federal Communications Commission, where she provided invaluable assistance to a team of wireless economists.  

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The FCC Spectrum Auction and the Future of Public Broadcasting: The Case at MSU and Greater Lansing

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Michigan State University (MSU) held a lively forum on 4 January 2016 to discuss the pending decision by the university on whether or not to participate in the FCC’s spectrum incentive auction. A second forum will be held on the 11th of January at 7pm in the College of Communication Arts & Sciences.

What might sound like a technically and financially arcane set of issues came to life for many in the questions of the 300 some participants who packed the auditorium on the 4th of January. It appeared as if every-other person attending the forum had their hand up at some point to comment or ask a question. Credit to MSU for holding these forums, and to the University’s President, Lou Anna Simon (2015), for being interviewed on WKAR’s ‘Current State’ in December about the pending decision.

If MSU were to auction off its broadcasting spectrum, as explained at the forum, this would spell the end of over-the-air (OTA) broadcasting of WKAR public television. Not being over the air, it will lose its financial support from the Corporation for Public Broadcasting, and its must carry status for cable and satellite providers. While it will not affect WKAR radio, it would threaten the existence of public broadcasting in the greater Lansing community, and similar communities, as well as the vitality of public broadcasting nationally (CPB 2014: chapter 3). Not surprisingly, the audience on 4 January was ‘overwhelmingly negative’ (Wolcott 2016). imgres

Why do this?

As the auction suggests, the ‘incentive’ is financial. Potentially hundreds of millions of dollars for the University, with no strings attached on how it is spent. However, there are seriously hard questions that need to be addressed before deciding whether such eye-watering payoffs for the University would really be a windfall or even justified at this point in time.

First, the same spectrum is likely to increase in value in the near future. Wireless is the most dynamic, fastest growing infrastructure for the development of innovative approaches to connectivity generally, but also mobile Internet, the Internet of Things, and future sensor networks associated with intelligent cities and transportation (Dutton et al 2014). There is little question that wireless spectrum is poised to become far more valuable than it is now, and within a short space of time. There is almost no question that any price MSU receives now will be short of what it will be worth in the space of 5-10 years. So is this too soon to auction it off, even if viewed on purely financial terms?

Secondly, those in the community who depend on OTA television will lose access to public television, and WKAR in particular. Only about three-fourths of Michiganians are online. In central Lansing, this could be closer to fifty percent. And many residents of the greater Lansing community are dependent on over-the-air broadcasting. The elderly, minorities, rural residents, and the less well to do, are among the most dependent on OTA broadcasting, and most in need of good high-quality programming, educational, and public-oriented programming (Lawson 2015).

Many believe that the Internet and related digital media will compensate for this loss. The idea is that digital media, such as the Internet, can be used to replace lost spectrum. In the short-term (for the next 5-10 years at least) this is a false hope. There are a growing number of ‘cord-nevers’ (never subscribing to cable or satellite services) and cord-cutters (those who stop subscribing) because they rely more on Internet access and streaming video services. This will reduce the likelihood of cable and satellite providers carrying public broadcasting.

Moreover, the fact that more people are moving to view television and film content over the Internet is not to say that everyone is. The reality is far from this imagined future. Digital divides in access to the Internet have been persistent in developed nations, such as the United States, and will not be closed in the next five to ten years. Michigan is about average among states across the US in access to the Internet, but that covers up major variations across socioeconomic groups, where access is dramatically variable.

Nor will the divide be fixed by other technical innovations. A digital switchover could provide better OTA broadcasting and more capacity, but that will not happen for years. New standards, such as ATSC 3.0 (Advanced Television Standards Committee 3.0), could diffuse as early as 2017. This new standard would improve the quality, spectrum efficiency, interactivity and mobile access, compared with current 1.0 standards, enabling a station like WKAR to broadcast content simultaneously receivable on phones, tablets, computers and home TV displays of standard, high definition and the ultra high def 4K video. ATSC 3.0 would be a ‘game changer’, but WKAR could not seize these opportunities if it lost this spectrum a year before they become active (Reid 2006). Moreover, the use of other platforms (e.g., Internet streaming, cable) comes with additional costs both for the content producer (should MSU continue to be) and the audience. An Internet provision of Lansing’s public television content would need huge funding to be competitive to viewers when TV remains the dominant media for news and entertainment. So again, with patterns of use still lagging far behind developments in new technology, is it too soon to cut off many in the community from over-the-air public broadcasting?

Thirdly, the spectrum was loaned to MSU for the purpose of providing public service broadcasting and information. All scenarios of this auction suggest that the funds received would be repurposed for other activities that might merit support on their own terms, but will not fulfill the public broadcasting purposes that formed the basis for MSU obtaining this spectrum. For example, the President of MSU suggested the proceeds could be placed into MSU’s endowment as a means to ensure its longevity, even though it is not a gift per se to the university (Simon 2015).

This is not a legal issue so much as one of public and community trust in the University fulfilling the spirit of public broadcasting or any other purpose for which money is given. The idea that the same content will be provided via other channels – meeting its obligation – is not plausible with the loss of PBS support and must carry status.

Finally, a number from the audience of the forum raised concerns over MSU losing a major platform for teaching. Many students are drawn to MSU to study broadcast production, and media production, generally. It is true that there are good universities, with strong schools of communication and media studies that do not have a public television studio and station. But why surrender one of MSU’s differentiating, strategic advantages in attracting and training its undergraduate students? It may be that more of a role in teaching could, and should, be made of WKAR’s presence at MSU, but auctioning off its OTA broadcast channel would undermine these opportunities.

In short, there are real issues revolving around the financial wisdom, public service obligations, the regional community, inequities, and educational opportunities tied to this decision. From my perspective, it is not simply an issue of either/or, but also of timing. I hope I am not seen as one of those so-called ‘naysayers’, to use Mark Bashore’s term in his interview with President Simon. Five to ten years from now, it is most likely that the spectrum will be far, far more valuable, and more people will be digitally connected, even if not online. Whether based on a matter of principle, or sound financial management, it might well be best to relinquish at this time.

So I am delighted that MSU is continuing to explore these issues. Perhaps there is good evidence to challenge each of these reservations I’ve outlined. In that spirit, I am looking forward to the second forum, and the potential to follow the Lansing case as a concrete, real world example of the opportunities, threats, and prospects for public broadcasting in the United States.

Bill Dutton
A personal perspective that does not necessarily represent the views of the Quello Center or any other organization.

References

CPB (2014), Corporation for Public Broadcasting, White Paper on Spectrum Auction and Repacking. 7 August. http://www.cpb.org/spectrum/reports/CPB-White-Paper-on-Spectrum-Auction-and-Repacking-Process.pdf?pdf=CPB-White-Paper

Dutton, William H. and Law, Ginette and Groselj, Darja and Hangler, Frank and Vidan, Gili and Cheng, Lin and Lu, Xiaobin and Zhi, Hui and Zhao, Qiyong and Wang, Bin, Mobile Communication Today and Tomorrow (December 4, 2014). A Quello Policy Research Paper, Quello Center, Michigan State University. Available at SSRN: http://ssrn.com/abstract=2534236 or http://dx.doi.org/10.2139/ssrn.2534236

Lawson, J. (2015), ‘Minority, public TV viewers face greatest threat in FCC auction’, 31 August: http://current.org/2015/08/minority-public-tv-viewers-face-greatest-threat-in-fcc-auction/

Reid, G. (2016), Comments at the MSU Forum, 4 January.

Simon, L.A. (2015), President Lou Anna Simon speaking on the future of WKAR-TV signal ‘to be determined in 2016’. Interview with Mark Bashore, 21 December 2015: http://wkar.org/post/pres-simon-future-wkar-tv-signal-be-determined-2016#stream/0

Wolcott, R.J. (2016), ‘Residents Concerned About Potential WKAR-TV Sale’, Lansing State Journal, January 5: 3A, 5A.

Notes

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