The following is an excerpt from FEELING SMART: Why Our Emotions Are More Rational Than We Think. Reprinted with permission from PublicAffairs.
One of the most intensely studied phenomena associated with auctions is known as “the winner’s curse”: in many cases the winner of an auction actually pays more for the item he or she has won than its true worth. This is a phenomenon observed not only in auctions of low-priced items whose participants are amateur bidders; large corporations bidding in major tenders are also prey to the winner’s curse. In the early 1970s many US oil companies collapsed shortly after they won auctions granting them drilling rights in several places in the United States. These corporations had large staffs of geologists and economists assessing the values of the drilling rights for which they were bidding, but it turned out that they had bid prices that were much higher than the true values of the drilling rights on offer, which eventually bankrupted them.
There are two main causes of the winner’s curse, one cognitive and one emotional. Participants in an auction try to assess the value of the item on auction as best as they can. They then submit initial bids that are slightly lower than that assessment. The more competitive the auction environment, the closer bids will be to the assessed value, because the more bidders there are in an auction, the higher the chances that someone else will outbid you.
If there are a very large number of bidders and they have conducted independent value assessments, it is reasonable to suppose that the average assessment will be quite close to the true value of the auctioned item. If that’s the case, then the winner of the auction, who has bid the most money, has made an offer higher than the average bid — meaning that it is probably higher than the true value of the auctioned item. This is the cognitive explanation for the winner’s curse. In other words, the participants fail to take into account the fact that if they submit the winning bid, then they are valuing the auctioned item higher than everyone else, which in turn means that they are likely to be overvaluing it.
One way to avoid cognitively falling prey to the winner’s curse is to write down the price you are willing to bid on a piece of paper that you then stow away in a drawer for twenty-four hours. After twenty-four hours have passed, take it out again and imagine that one of the auction officials who has already seen all the other bids informs you that you have submitted the highest bid. You should now recalibrate your bid based on this information. In most cases, this will lead you to lower your bid, protecting you from the winner’s curse.
But there is also an emotional cause to the winner’s curse in many cases. Participants in auctions often find themselves driven to submit high bids by “auction fever” — an uncontrollable desire to win the auction at any price. A few years ago two students of mine asked me to suggest a research project. My advice was to find Web sites in which the same items were offered for sale in two different ways — by auction versus direct sale at a fixed price — and to compare the prices at which the items were eventually sold.
I hypothesized that the auction prices would in many cases be higher than the direct sale prices for the same items, and my hypothesis turned out to be true. The auction participants could have obtained what they had bought by auction at lower prices if they instead had gone to direct sales at the same site, but the competitiveness of the auction environment and the auction fever that accompanies it pushed them to pay much more.
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