Winner s Curse

Winner’s Curse

Sometimes winning an auction signals that you lost. Although in the previous sections it was assumed that you knew how much the good was worth to you, sometimes you don’t have full information about the good’s quality. For example, imagine that several oil companies are bidding for the mineral rights to some land. Each oil company sends a team of geologists to determine the likelihood of the land having oil. No company knows everything, and all companies unearth some slightly different information. Let’s say 10 companies bid, including yours. You win, and it turns out you bid far more than most people. This means that your geologists thought that the land was more valuable than the geologists at the other companies did. There are now two possibilities: Everyone else is wrong and your geologists correctly determined the value of the land, or everyone else is correct and you overbid. While your geologists might be the best, the odds favor your having made a mistake.

Consider a simple analogy. You are in a room with 10 other people. You ask each person to guess your weight. Chances are that the person who guesses the highest overestimated your weight. The winner of an auction is the person who guessed that the good being sold has the highest value, and so odds are that he overestimated the good’s value.

Winner’s curse applies only when you are uncertain of the good’s value. Imagine that you are determined to buy my book, which is being sold for, say, $30 at your local store. Before purchasing it, you decide to check for a copy on eBay. If you are definitely going to buy my book, you know it’s worth paying up to $30 because that’s how much getting the book on eBay would save you. There can be no winner’s curse in this example because if you pay less than $30 (including shipping), you are better off.

Now imagine that you first encounter my book on eBay. Many people place bids, but you win. You must have a higher estimate of my book’s value than any other seller does. Maybe you have insight into my brilliance that others lack. But perhaps you have overestimated my literary worth.

When you are uncertain of a good’s value, then you learn something from everyone else’s bid. High bids signal that others greatly value the good, while low bids show that your fellow bidders don’t think the item has much worth. If the other bidders might know something about the auction item that you don’t, then their bids should influence how much you are willing to pay.

Winner’s curse afflicts sellers as well as buyers. When buyers are uncertain of a good’s value, then they fear paying too much. Winner’s curse will cause all buyers to bid less and will consequently reduce the seller’s take. To combat winner’s curse, sellers need to provide information about their goods so that buyers will realize the good’s value and won’t fear the winner’s curse.