The Joy of Economics:  Making Sense out of Life
 Robert J. Stonebraker, Winthrop University
 

The Winner's Curse

 

 

 

            For all we take we must pay, but the price is cruel high.

                                                                                                .....Rudyard Kipling

 

 

            Auctions are a venerable economic tradition.  College students furnish their apartments with purchases from local estate sales, museums and connoisseurs build their collections through art and antique auctions, and farmers study the latest livestock quotes.  Auctions have even gone high-tech; thousands of auctions are run on-line every day over the World Wide Web offering everything from stuffed aardvarks to antique zithers.1 

 

            We all are looking for the golden goose, the undiscovered treasure available for pennies on the dollar.  My own auction purchases include a piano stool, two chests of drawers, a designer teddy bear, a 1956 Ted Williams baseball card, and a house.  Occasionally we are rewarded.  Occasionally we come across "a steal," and make a real killing.  Most often we do not.

 

            Imagine the following scenario.  Randy Johnson, star pitcher for the Arizona Diamondbacks, tires of sunshine and salamanders and enters baseball's free agency market.  After a spirited bidding war among Major League clubs, the New York Yankees land Johnson with an offer of $250 million plus five percent of the Yankee's annual gate revenues.  Yankee management and fans are ecstatic about their good fortune.  Should they be?  Although there have been exceptions, most free agents turn out to be far less valuable than their employers had anticipated.2  The winners in free agent bidding often turn out to be losers.

 

            Baseball moguls are not the only ones to experience such disappointments.  Oil companies that win bidding contests for off-shore drilling leases often lose money on them.  Book publishers that "win" the rights to publish potential best-sellers are often disappointed with subsequent sales.  Winners in corporate take-over struggles frequently end up swimming in red ink.  All have fallen prey to what economists call...the winner's curse.3

 

            The basic message is simple, yet powerful.  In any auction there is some uncertainty about the true value of the item up for bid.  Each bidder will estimate what she thinks is the true value.  Given the uncertainty, some people will underestimate the true value while others will overestimate.  Since the person with the most optimistic assessment of the object's value will be the high bidder, the auction winner is likely to have overbid.  In other words, if you have no inside information, yet outbid 100 other people on an item, you should worry.  If you paid for than anyone else was willing to pay, you probably paid too much.

 

            Suppose you are a real estate developer contemplating a $200,000 bid for a parcel of land. Most of us might ask: "Am I willing to pay $200,000 for this land."  However, the winner's curse cautions us to ask: "If no other developer is willing to pay $200,000, am I still willing to bid $200,000.

 

            Of course, things change if you are the only developer.  If no other bidders appear, very conservative bids are enough to walk off with the prize.  Theory suggests, and experiential evidence corroborates, that the winner's curse is more like to emerge in auctions with large numbers of bidders.  The more people you must outbid, the greater is the probability that you will overbid.4

           

Is it rational?

 

            How widespread is this phenomenon?  A former student, always alert to the possibility of a clever insult, noted that universities bid for faculty.  If winners overbid, as the winner's curse suggests, then all professors, including me, must be overpaid.  Whoa. That sounds a bit distressing.

 

            The larger issue involves rational behavior.  Why would rational people continue to participate in auctions in which the winners lose?  Would not rational people eventually catch on to the problem, and either lower their bids or drop out altogether?  They should.  And in many cases, they do.  However, information is costly to obtain and digest.  If it were not so, students would score 100 percent on every exam without study.  Rational economic agents pursue additional information only when they perceive the likely benefit of the information will exceed the cost of learning it.  The result?  People will make mistakes; unsophisticated bidders will overbid.

 

            In the mid-1990's the Federal Communications Commission (FCC) decided to allocate a largely unused part of the electromagnetic spectrum to firms wanting to provide personal communication services (PCS), services which would compete with cellular phone and paging systems already in operation.  Knowing that the number of potential providers would exceed the number of available slots in the frequency spectrum, the FCC announced it would auction the available licenses to the highest bidders.  The FCC reasoned that such an auction would allocate the scarce frequencies to their most valuable uses.  Those seeing the frequencies as being the most valuable would outbid others.  In addition, the auction could raise big bucks for the agency. 

 

            The initial result was hugely successful.  The auction attracted hundreds of interested buyers, and firms bid over $10 billion in the scramble for scarce licenses, well in excess of what FCC officials had projected. 

 

            Could sophisticated communication firms have irrationally overbid?  Some of these firms actually hired professional economists to advise them on biding strategy.  Could such firms fall prey to the winner's curse?  Yes.  A number of several successful bidders hit the financial skids within months and, hats in hand, petitioned the FCC for relief.  FCC officials, trying to thwart potential bidder-bankruptcies, agreed to ease payment terms.5  People do make mistakes; even sophisticated bidders will sometimes overbid.

 

Try it yourself

 

            Hungry?  Need some lunch money?  Economist Richard Thaler suggests trying the following experiment.  Fill a large jar with pennies -- make sure you count how many you insert. Next, auction off the contents of the jar.  In case bidders have an aversion to pennies, offer to pay the winning bidder in currency and larger coins instead.  What should happen?  First, the average bid should be significantly less than the value of the pennies (most bidders are cautious or risk averse).  Second, the winning bid should exceed the value of the jar (the winner's curse). 

 

            I tried a similar experiment with mid-career MBA students.  I filled a jar with 298 marbles and offered a prize of one cent per marble to the highest bidder.  Students passed the jar around the class and examined it from all angles trying to estimate the correct number of marbles residing inside.  They considered this far more interesting than listening to my lecture.  Each student then submitted a written bid based upon their individual appraisals. The results?  Just what Thaler predicted.  The average bid was $2.57, a conservative $0.41 below the true value.  The high bid was $3.50, enough to give me a net gain of $0.52 that I gleefully collected from the winning (losing?) bidder.  My students learned a valuable, first-hand lesson about the winner's curse, and I gained a hot dog at the local convenience store.  What a deal.

 

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Notes:

 

1.         Check out www.eBay.com, one of the more popular electronic auction sites.

2.         Baseball fans will know that the Yankees did indeed trade for Johnson before the 2005 season and sign him for two years at $32 million.  As we might expect, Johnson's performance was below expectations. For a statistical analysis of winner's curse issues in baseball free agent markets, see Burger, John D. and Stephen J.K. Walters, "The Existence and Persistence of a Winner's Curse: New Evidence from the (Baseball) Field", Southern Economic Journal, volume 75, number 1, July 2008, pp. 232-246.good discussion

3.         These examples, and much of the following logic, can be found in Thaler, Richard H., The Winner's Curse: Paradoxes and Anomalies of Economic Life, Free Press, New York, 1992, pp. 50-62.

4.         See Thaler, ibid., page 55.

5.         See "FCC Offers New Options for Wireless Licenses," New York Times, September 26, 1997.

 

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Testing Yourself

 

To test your understanding of the concepts in this reading, try answering the following:

 

1.         Explain the concept of a "winner's curse" and give an example.

 

 

 

 


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Last modified 05/22/13