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January 1, 1995

eCONOMIC
GOMMeNTORY
Federal Reserve Bank of Cleveland

Allocating Publicly Owned Assets: The
Case of Personal Communications Services
by Ian Gale

I

n late July 1994, the Federal Communications Commission (FCC) began an
unprecedented sale of the airwaves.
Large segments of radio spectrum (frequencies) were sold in a series of auctions, enabling firms to provide new telecommunications services. First to be sold
were 4,900 radio licenses for two-way
paging services, voice messaging, and
data services, allowing receipt of faxes
by hand-held devices, for example.1
Next to be sold are about 2,000 licenses
for wireless telephone services known as
personal communications services
(PCS). PCS systems will transmit calls
via radio waves using digital technology.
As with current cellular telephone systems, there will be many "base stations,"
and calls will be relayed from station to
station as the caller moves around.
The use of auctions to allocate radio
spectrum was mandated by Congress
when it amended the Communications
Act in 1993. In designing the auctions,
the FCC has built on the experience of
previous spectrum auctions in Australia,
New Zealand, and the United Kingdom.
This action marks the first time that the
airwaves have been sold by the federal
government. Until last July, licenses had
been allocated through comparative
hearings or lotteries, both of which consumed substantial resources but failed to
raise any revenue. The mounting federal
debt was a major impetus for the auctions, and the initial series of auctions in
fact raised far more than initial government estimates had predicted.

In addition to their favorable impact on
the federal debt, the auctions will increase competition and lower rates for
the approximately 17 million current
cellular telephone users, while also providing higher-quality service. This Economic Commentary examines the rationale for using auctions to allocate radio
spectrum. A secondary focus is on the
impact of firms' capitalization on their
bidding. In the past, concern that small
firms did not have sufficient capital to
compete with larger firms led to many
government giveaways. Moreover, preferential treatment for small firms has had
undesirable side effects. In particular, setasides, which reserve certain licenses for
bidding by small firms only, reduce bidding competition and lower revenue.
The formats chosen for the spectrum
auctions avoid many of the problems
associated with the earlier allocation
schemes. Although some set-asides have
been used, allowing small firms to pay
in installments mitigates their capital
constraints and permits them to be more
aggressive bidders.

• Allocation of Publicly
Owned Assets
The federal government has frequently
used auctions to allocate publicly owned
assets. The best-known examples are
Treasury bill and Treasury bond auctions. Others include auctions of timber
harvesting rights and mineral extraction
rights, as well as real estate (by the Resolution Trust Corporation). None of
these auctions is controversial, and their

For the first time in U.S. history, the
federal government has begun a sale
of the airwaves. Sales of radio spectrum, conducted in a series of auctions last summer, will promote new
telecommunications services, and
upcoming auctions will sell licenses
for wireless telephone systems known
as personal communications services.
These activities represent an appealing way to allocate scarce resources,
will help put a dent in the federal
debt, and will be fair to small firms
facing capital constraints.

longevity suggests that auctions may be
an appropriate method for allocating
such assets. Yet in many other cases,
bidding is not used.
Political considerations have limited the
use of auctions, resulting in the awarding of assets with little or no payment.
Radio and television licenses and cellular telephone licenses provide cases in
point. (No fee was charged in the cellular telephone lotteries, other than for
nominal processing.) In the airline industry, takeoff and landing slots were
simply given to incumbent carriers after
the Airline Deregulation Act was passed.
Such giveaways represent transfers
from the federal government (and thus
from taxpayers) to small groups of firms
or individuals. They also generate substantial lobbying aimed at maintaining
the status quo.

In many other settings, assets have been
allocated without bidding because of a
belief that auctions are somehow
inequitable. For instance, bidding is not
typically used to allocate office space for
university faculty or study carrels for
graduate students, presumably to avoid
having the spoils go only to the wealthy.
There are notable exceptions, however.
At the University of California at Los
Angeles, graduate students in economics
bid for study carrels, and the Economics
Department at Arizona State University
has allocated offices through an
auction.2 These examples suggest that
economists give relatively more weight
to efficiency—the idea that an asset
should be deployed where it is valued
most highly—than to equity.
When office space or a study carrel is
allocated by a non-auction mechanism,
the winner is typically unable to convey
the office or carrel to someone else. In
other settings, however, resale is common. For example, the Bureau of Land
Management estimated that fewer than
5 percent of the winners of onshore oil
and gas lease lotteries actually engaged
in exploration.3 The FCC now estimates
that of all the cellular telephone licenses
awarded to firms other than local telephone companies, 85 percent had been
resold by 1992. The value of those latter
licenses could be as high as $10 billion,
but the federal government received no
money for them.4
Resale tends to put the license in the
hands of the firm that is willing to pay
the most, which is what an auction
would accomplish in the first place. In
addition, spectrum currently used for a
television station could be employed for
cellular telephone service or PCS,
thereby providing much greater benefits.
Allowing resale of spectrum or changes
in its utilization (subject to controls on
issues such as interference with existing
users) will tend to put spectrum to the
use that benefits society the most. Resale
can also make the initial bidding more
competitive, because bidders foresee the
possibility of selling to another firm in
the future. Thus, permitting resale tends
to be beneficial.

•

Benefits of Auctions

When Congress instructed the FCC to
allocate radio spectrum, it could have
mandated any of several different methods, including lotteries, comparative hearings, first-come first-served, and auctions.
A lottery can certainly raise revenue, but
there is often a significant delay before
service begins, since many of the licenses
will be resold. When the FCC used open
lotteries for cellular telephone licenses, it
took more than a year for service to begin, on average. In addition, because the
fees were so low and the values of the
licenses were so high, nearly 400,000
applicants clamored for an opportunity.
Processing these applications imposed a
massive cost on the FCC.
Comparative hearings have been used
extensively to award radio and television
licenses. Drawbacks to their use again
include the cost (to the FCC and the
applicants) and the delay. In "streamlined hearings," the FCC took an average of two years to award cellular telephone licenses in the top 30 markets. If
the PCS licenses were allocated by hearings, the process would take several
years, and millions of dollars would be
spent attempting to influence the outcome. And if licenses were awarded on a
first-come first-served basis, there is a
danger that inferior technologies would
be used in a rush to be first.5
Auctions avoid many of the drawbacks
of these other schemes. In an auction, the
object for sale is awarded to the bidder
who offers to pay the most. Because this
bidder is typically the one who values the
object most highly, the outcome is efficient. Moreover, under plausible conditions, a simple auction yields the maximum possible revenue to the seller.6
Even though auctions have many appealing features, however, additional issues
must be raised—chiefly, how to respond
to the existence of capital constraints.

•

Capital Constraints

Whenever auctions are used to allocate
government-owned assets, some small
bidders claim to be at a disadvantage relative to their larger counterparts. The
implication is that large firms, by virtue
of greater financial clout, can outbid the
smaller firms. If bidders face capital

constraints, there may be a divergence
between how highly a bidder values the
good and what he is able to pay.
For illustrative purposes, consider a bidder seeking to buy a small business. The
business is worth $250,000 to the bidder
in the sense that this is the maximum he
would pay in the absence of any capital
constraint. The bidder may have at his
disposal only $10,000, however. He may
be able to get a loan to purchase the business, but will have difficulty doing so
and will face a high interest rate. In this
sense, the bidder has a severe capital constraint. If many of the bidders confront
such constraints, then the seller may find
it optimal to offer below-market interest
rates to increase competition.
Capital constraints are present in many
other cases, although not as dramatically.
The bidder could be a firm that faces a
high cost of capital because its cash flow
is low. Again, a divergence occurs
between the value of the object to the
bidder and what he is able to pay. These
issues are of paramount importance
because of the popular, but largely
unfounded, belief that small firms create
a disproportionate share of net new jobs,
which creates pressure to give small
firms preferential treatment.7
In government auctions, there is anecdotal evidence of concern about the limited
financial resources of bidders. For example, the federal government has limited
the length and size of mineral leases,
thereby making small firms more competitive.8 In timber rights auctions, setaside sales have been made available
exclusively to small firms. Royalty payments, which are popular in mineral
rights auctions, provide a method of
spreading the winner's payments across
periods, thereby mitigating the impact of
the current capital constraint.9
Researchers Kenneth Hendricks and
Robert Porter provide additional evidence of the importance of capital constraints.10 Since 1975, Outer Continental
Shelf (OCS) regulations have permitted
joint bidding by all but the eight largest
firms. The authors study bidding behavior on OCS leases for the period 19541979, focusing on the impact of joint

bidding on bids and profit rates. Their
findings on the profitability of joint ventures involving a large firm and small
fringe firms are of particular interest.
Formation of the joint ventures apparently leads to more competitive bidding.
The authors suggest that these joint ventures are "motivated primarily by capital
constraints."11
Even if one accepts the argument that
small firms are at a relative disadvantage,
there remains the question of how to
assist them. Bidders with low liquid
assets will be able to compete effectively
in auctions if 1) they can pay in installments, 2) they are given "bidding credits" so that their bids are treated as if they
were larger than they in fact are, 3) the
licenses are made sufficiently small (for
example, covering narrow geographical
areas) that their value is low relative to
the liquid assets of the small bidders, or
4) some licenses are set aside for bidding
by small firms only. The last of these
possibilities is the least appealing, since it
reduces competition for the licenses that
are set aside, thereby lowering revenue.
The other three options enhance competition, although making licenses small may
forsake economies of scale.
The FCC ultimately decided to set aside
a small number of licenses for companies with revenues below $125 million.
In addition, in many other auctions,
small businesses received bidding credits (discounts) as high as 25 percent. The
size of the bidding credits depends on
the size of the firm as well as on the sex
and race of the owner. The use of installment payments was also offered.

•

Bidder Capability

The FCC would like to be certain that
service will begin in a timely fashion. As
such, it may wish to seek assurance that
bidders are capable of providing the
service. An engineer's report was required in the FCC lotteries of cellular
telephone licenses, spawning a cottage
industry that produced such reports. By

the end of the lottery, an application cost
approximately $650 to prepare, including the application fee.12 Thus, it did
not represent much of a burden for the
participants, nor did it indicate capability. In the PCS auctions, the FCC took a
different tack: Winners risk losing their
licenses if they have not installed networks serving one-third of the potential
customers within five years.13

•

The Form of the Auction

Auctions can take many forms. For example, objects can be sold sequentially or
simultaneously, and bidding can be open
or by sealed bid. A simultaneous auction
would allow firms to put together bids
for packages of licenses covering adjacent geographical areas, but may necessitate withdrawal of bids if other bidders
are awarded some parts of the package.
A sequential auction would allow firms
to make bids knowing which licenses
they had already acquired, but it does not
give firms the opportunity to express
their valuations for packages of licenses.
The FCC decided to use a form of simultaneous auction for the large markets and
to use sequential auctions for the small
markets. Ultimately, differences in formats are less important than the fact that
auctions of some form were held.
•
The Initial Results
The FCC started the spectrum auctions
with the sale of 10 nationwide narrowband licenses. The auction commenced
on July 25, 1994, and took 46 rounds
and five days to complete. When it was
over, $617 million had been raised—10
times what the Congressional Budget
Office and the Office of Management
and Budget had predicted.14 No small
firms won nationwide licenses, however. (Bidding credits were offered on
three of the 10 licenses.) The revenue
raised in this initial offering bodes well
for the auction of the more valuable
broadband licenses.

•

Conclusion

The auction of PCS licenses represents a
bold step forward, and the results from
the nationwide narrowband auctions are
promising. An auction is an appealing
method of allocating scarce resources
because it awards the object to the bidder who offers to pay the most, thus
maximizing social welfare while raising
revenue. If firms differ only in their cost
structure, then the low-cost firms should
win a large share of the auctions—the
efficient outcome.
A caveat is that some firms may have
low costs but be undercapitalized. The
use of installment payments or bidding
credits is a desirable response and is
preferable to the use of set-asides, which
arbitrarily limit the number of bidders
and thereby reduce revenue. The ultimate
test of the limited set-aside program
offered in the spectrum auctions will be
whether the successful small firms stay
in the market and flourish or sell their
licenses as soon as they are able.

•

Footnotes

1. These are known as "narrowband"
licenses and are not well suited for voice
communication. The others are "broadband"
licenses.
2. The public relations problems associated
with auctioning off faculty offices—even
when the proceeds go to a fund to support
graduate students—are documented in
William J. Boyes and Stephen K. Happel,
"Auctions as an Allocation Mechanism in
Academia: The Case of Faculty Offices,"
Journal of Economic Perspectives, vol. 3,
no. 3 (Summer 1989), pp. 37-40.
3. See C. Fred Bergsten, Kimberly Ann Elliott, Jeffrey J. Schott, and Wendy E. Takacs,
Auction Quotas and United States Trade Policy, Washington, D.C.: Institute for International Economics, vol. 19, 1987.
4. See "The Sky's the Limit," Washington
Post, June 5, 1994. The profits that accrue to
resellers also raise public ire. The incumbent
mayor of Charlotte, North Carolina, lost his
bid for reelection in 1987 after it was learned
that an investment group in which he participated sold a broadcast license four months
after receiving it from the FCC. Documents
indicated that the then-mayor stood to make
more than $400,000 on the transaction. See
"Gantt Might Have to Live with TV Station
Uproar All Over Again," Charlotte Observer,
March 24, 1990.

5. For additional discussion, see Evan
Kwerel and John Williams, "Moving toward a
Market for Spectrum," Regulation, vol. 16,
no. 2 (1993), pp. 53-62.
6. In the revenue-maximizing auction, the
seller may set a minimum acceptable bid. See
R. Preston McAfee and John McMillan,
"Auctions and Bidding," Journal of Economic Literature, vol. 25, no. 2 (June 1987),
pp. 699-738. Their analysis does not consider
capital constraints explicitly.
7. This point is made convincingly by Steven
J. Davis, John Haltiwanger, and Scott Schuh,
"Small Business and Job Creation: Dissecting
the Myth and Reassessing the Facts," Business Economics, vol. 29, no. 3 (July 1994),
pp. 13-22.
8. The Mineral Leasing Act and the Outer
Continental Shelf Land Act explicitly limit
the size of leases, but allow consolidation of
leases after bidding is complete. Leases are
limited to five and 10 years for producing and
nonproducing tracts, respectively. See C. Fred
Bergsten, et al., Auction Quotas and United
States Trade Policy (footnote 3).

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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9. Between 1953 and 1982, the revenue
raised from royalty payments in Outer Continental Shelf auctions amounted to $17.3 billion, or 41.9 percent of the revenue raised
from up-front bids. See Kenneth Hendricks
and Robert H. Porter, "Joint Bidding in Federal OCS Auctions," American Economic
Review, Papers and Proceedings, vol. 82, no.
2 (May 1992), pp. 506-11.
10. Ibid.
11. Ibid., p. 510. Stephen McDonald reaches
a similar conclusion in The Leasing of Federal Lands for Fossil Fuel Production, Baltimore: Johns Hopkins University Press, 1979,
pp. 106-07.

14. See Peter Cramton, "Money out of Thin
Air: The Nationwide Narrowband PCS Auction," Journal of Economics and Management Strategy, forthcoming 1995.

Ian Gale is an economist in the antitrust division of the U.S. Department of Justice, Washington, D.C., and a former economic advisor
at the Federal Reserve Bank of Cleveland.
The views stated herein are those of the
author and not necessarily those of the Federal Resetve Bank of Cleveland, the Board of
Governors of the Federal Reserve System, or
the U.S. Department of Justice.

12. See Thomas W. Hazlett and Robert J.
Michaels, "The Cost of Rent-Seeking: Evidence from Cellular Telephone License Lotteries," Southern Economic Journal, vol. 59,
no. 3 (January 1993), pp. 425-35.
13. See "U.S. Lays out Rules for Big Auction of Radio Airwaves," New York Times,
September 23, 1993.

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