Management & Organization

Beware of the winner's curse

You are at an auction and have your eyes set on a beautiful antique pocket watch that you would like to take home with you. The auction begins and the bids are flying through the air. The suspense increases and the adrenalin is pumping. You make a bid. The opponent makes a bid. You are thinking: “He is definitely not going to get it”. In the heat of the battle you suddenly bid more than you had decided. This pocket watch has to belong to you. You bid once more. Finally it is over, your opponent has given up. You have won and the Swizz pocket watch is yours. But was the 15.000 worth it?

A lot of people can recognize that situation. Not just trough antique auctions, but also in corporate life it often happens that companies bid more on a product, contract, agreement or business than it is rationally worth. They have become struck by the curse of the winner.

An evil auction

And auctions can be terribly devious. A particularly evil example that illustrates the curse of the winner is “the entrapment game” or “the 20 dollar auction”, which was initially described by the Yale economist Martin Shubik. It happens like this: An auctioneer informs a group of people that he wants to auction a 20 dollar bill. When the bidding stops the highest bidder receives the 20 dollars. But both the one that bids the highest and the one that bids the second highest has to pay their bidding to the auctioneer.

Imagine how such an auction plays out in a competitive environment: The highest bid is 10 dollars and the second highest is 9 dollars. If the auction stops here, the highest bidder receives the 20 dollars for his 10 dollars and collects a profit of 10 dollars. The auctioneer collects 19 dollars from the two bidders and loses 1 dollar. The second highest bidder loses 9 dollars just for choosing to enter the auction. On the other hand, if he chooses to raise his bidding by 1,50 dollars, making $10,5, he can win the 20 dollars with a profit of 9,50 dollars. This means that the previous “winner” loses his 10 dollars and only by continuing to bid does he have a chance of making a profit.

As you can see there is a considerable price to pay being second, which of course motivates the contestants to continue bidding.

One could be tempted to believe that any intelligent person would be too clever to participate in such an auction in the first place. But many of the contestants in this type of auction has been experienced businesspeople and many have received lecturing in game theory and strategy. Harvard professor Max Bazerman have on numerous occasions put his students through this experiment. Every time the students have bid more than 20 dollars for Max’s 20 dollar bill.

 In this experiment the value of the product is known. A 20 dollar bill is worth 20 dollars. Then imagine what would happen when the value of the product is uncertain and depends entirely on the individual valuation of the contesters.

This is illustrated in another classic example. Here a jar of coins are auctioned. The jar has the same value for all. But every bidder has his own valuation of how many coins the jar contains. Averagely the guesses may very well be accurate, but if the winner is the most optimistic bidder, his bidding is very often too high.

The same mechanism is to be found in games, for example when companies bid on the license to drill for oil, buys another company, or when a football club buys a new player. In all three cases the exact value of the product is uncertain, and therefor there is a great chance that the company pays too much.

 The auction of a jar of coins is used by Max Baserman to examine which factors that influences in which degree people are likely to to bid above the actual value of a product. His research shows that the margin of error is negatively affected by the degree of uncertainty regarding the value of the product and the number of bidders.

How to avoid the curse of the winner

How do you avoid being the prey of the curse? Besides staying far away from the auction?

  1. First you have to examine if the product that is being auctioned has a “private value” or a “public value”. A product with a private value is a product whose value depends on the individual bidders’ ability to exploit the product (thereby increasing its value). For example, if your company has a specific technology that allows you to extract more oil than your rivals. A product with a public value has the same value for all who bids, for example the previous mentioned jar of coins. If the product entirely has private value the winner of the auction does not need to fear the curse of the winner. Although often the product is actually a hybrid of the two. This forces you to assess which of the two values that has most use or is more important.

  2. Second you have to, if the product turns out to HAVE private value, find out if you have an advantage compared to the other bidders regarding your ability to exploit the product. You have to assess is you can get a greater value of the product – and therefor bid a higher price.

  3. Third you have to consider, before you make a bidding, how you would feel if you won he auction. Is it a bid that makes you feel comfortable?

  4. Finally it is important to recognize when you have lost. A lot of executives becomes irrationally optimistic when the fear of losing meets the desire to follow the path that they have invested time, money and energy in. Instead they stand on the brink of disaster clinging to a hope for things to get better.

Sources:

Max H. Bazerman and William F. Samuelson: I Won the Auction but Don't Want the Prize. (The Journal of Conflict Resolution, Vol. 27, No. 4 (Dec., 1983), pp. 618-634)

Anandalingam, Ralph J. Tyser, Henry C. Lucas Jr., Robert H. Smith:Beware the Winner's Curse : Victories that Can Sink You and Your Company(2004).