Auction Winners pay over the Odds | The Winners Curse
Have you ever attended an auction or maybe made a winning bid on ebay?
You may have fallen victim to the ‘winners curse‘ without realising it! This is an Economic/mathematical theory that suggests you may have paid over the odds by using this medium of purchase.
Auctions have been around for a long time, let’s first outline the different types of auction quickly.
English Auction – This method is used in British Art houses in which the bidding goes up until there is only one bidder is left.
Dutch Auction – Used in the Dutch flower markets for example, the price drops until it reaches a price someone will pay.
In a ‘first price auction‘, bidders submit sealed bids and the highest bidder wins. There is a fourth type of auction similar to the English auction in which the winner pays as much as the second-highest bid.
An Economist named ‘William Vickery‘ famously examined types of auction and suggested that it was in bidders best interest to bid less than their valuations.
This strategy auction theorists call ‘shading’ which gained special significance in the 1970′s when it seems that oil companies bidding for offshore drilling rights often ended up paying far too much.
Auction theorists discovered the phenomenon of the ‘Winner’s curse’: an item goes to the bidder who overvalues it the most.
The ‘winners curse’ transpires due to the following process, in an auction where the value of the sale item is uncertain, every bidder make his own decision on its value.
If they decide their valuations privately, there will be a range of different valuations. The true value of the item will tend to be around the mid-range of the different bidders valuations. The sale will go to the bidder who overestimates its value the most.
Therefore Auction winners pay over the odds.
The main point about this theory is that winning an auction conveys bad news about the price paid by the winning bidder, if the other participants are correct with their valuations on average, then too much was paid on the winning bid.
The severity of winners Curse increases with the number of bidders. This is because the more bidders there are, the more likely that some of them will have overestimated the auctioned item’s value.
In the 1950-1970s when the term winner’s curse was first coined, there was no accurate method to estimate the potential value of an offshore oilfield. So if, for example, an oil field had an actual intrinsic value of $10 million, oil companies might guess its value to be anywhere from $5 million to $20 million. The company who wrongly estimated at $20 million and placed a bid at that level would win the auction and later find that it was not worth as much.
Therefore falling victim to the theory of the winners curse.
You may note that ebay favors the auction type similar to the English auction in which the winning bidder pays the price of the second-highest bid. This would mean that you only win an auction if your valuation of the item is higher than any other participant.
The next time you make a bid on ebay, remember this little Economic theory and make sure you don’t overpay and fall victim of the winners curse !!