Winner’s Curse

If you’ve ever been to an auction, you know that it can be a high-pressure, intense, and an exciting experience. As items begin to go up for bid, and people around you begin to raise their paddles, maybe you’ve started to wonder if you too should bid on the item. You might not have intended to bid on the item, but it feels like everyone else recognizes its value. Not wanting to miss out, you and other auctioneers continue to make higher and higher bids. Finally, someone wins the item. They might initially feel like they’ve won and secured the valuable item, but upon further reflection, they will realize they overpaid.

In these emotional and overwhelming situations, it can be difficult to make rational decisions about an item’s value, and people often fall victim to the winner’s curse. The winner’s curse is the tendency for the winning bid to exceed the worth of an item.¹ The person who wins the bid overestimates its worth the most, as they were willing to go above and beyond what a presumably rational person is willing to bid. So, the fact that they won means they paid more than the item is actually worth in the market, as they pay more than other people have valued the item at.

Intrinsic Value: the actual value of an asset’s worth. It is determined through objective financial analysis and does not take into account the currently trading market price of that asset.³

Expected Value: the bidder’s own estimated value of an asset, which increases as the number of bids increase.⁴

Auctioned Value: the value at which the asset is auctioned for, which ends up matching the highest bidder’s expected value.

Common Value Auction: situations in which the intrinsic value of the item is the same for everyone, but people have different levels of information about what the actual value is.⁵

Market Efficiency: a market where the price that an asset is selling for (its trading market price) is equal to its intrinsic value. The hypothesis speculates that prices reflect all information and that stocks always trade at their fair value.⁶

Buyer’s Remorse: a period of regret and discomfort after making a purchase. The winner’s curse often leads to buyer’s remorse after reflection on the intrinsic value of the auctioned item.⁷

Linkage Principle: a phenomenon that reflects the tendency for open auctions (where everyone gets to know everyone else’s bids) to yield higher auction prices than sealed-bid auctions (where all bidders submit their bids at the same time and don’t know the bids of other participants).⁴

In 1971, three petroleum engineers working for Atlantic Richfield looked over the records of various oil companies after realizing that oil companies were suffering unexpectedly low returns on their investments yearly. Edward Capen, Robert Clapp, and William Campbell examined the low returns that occurred as a result of the Outer Continental Shelf oil lease auctions. In particular, they noticed that companies bidding on oil in the Gulf of Mexico — an area that had a lot of oil and gas at this time — were making peculiarly low returns. Since the area was dense with oil and gas, companies should have been able to buy oil at a relatively low price and sell it for a good profit.⁸

The petroleum engineers speculated that it was because of the competitive bidding environment that businesses were failing to make the return they expected. They believed that bidders did not have sufficient knowledge of the laws of probability to make rational informed decisions, and instead were being swayed by the bids of other oil companies.⁸

The value of oil in the ground should have a similar value for all bidders, yet, when it is auctioned off, bidders must fight to outbid their competitors. This is partially because there was no method to estimate the potential value of an oil field, so bidders had to rely on intuition. However, in high-pressure situations, intuition can veer from rationality, like an auction.⁸

The method in which an auction is set up ensures the winner has to be an individual who is willing to pay more than everyone else – so, unfortunately, the winner is doomed to pay more than the oil’s inherent value. After investigating this common occurrence in oil bids, Capen, Clapp and Campbell coined the term “winner’s curse” to describe this phenomenon in their article “Competitive Bidding in High-Risk Situations.” They came up with three rules for people to avoid the winner’s curse:

1. The less information one has compared with what his opponents have, the lower one ought to bid.
2. The more uncertain one is about his value estimate, the lower one should bid.
3. The more bidders (above three) that show up on a given parcel, the lower one should bid.⁸

These rules suggest that, unless bidders are well-informed and able to rationally calculate the inherent value of an oil field, they should be conservative with their bids.

Following the petroleum engineers’ investigation and discovery of the winner’s curse, professors of management Max H. Bazerman and William F. Samuelson, who specialized in negotiating and bidding, ran experiments to test its validity. They published a paper in 1983 titled “I Won the Auction but Don’t Want the Prize.” ⁹ Similarly to Capen, Clapp, and Campbell, Bazerman and Samuelson hypothesized that the reason the winner’s curse occurs is because a relevant piece of information is excluded from the decision-making processes of bidders — if an individual assumes that their bid will win, they should realize that they have overestimated the value of a commodity and revise their bid. However, it is hard to know whether or not your bid will be successful unless you know the other bids before you make yours.

Bazerman and Samuelson identified two factors that increase the likelihood of the winner’s curse: the degree of uncertainty and the size of the bidding population. The more uncertain people are about the inherent value of an item and the bigger the bidding pool, the more likely the winner’s curse is to occur. To test their theory, the researchers recruited MBA students to participate in four sealed-bid auctions. All commodities had a value of $8, and participants were told that they would receive a $2 prize if they had the bid closest to the inherent value of the item, so as to encourage reasonable bids.⁹

Bazerman and Samuelson found that despite the incentive, the highest bids often exceeded the inherent value of an item. Subjects employed naive bidding strategies, even in a sealed bid situation. They also found that as predicted, increasing the degree of uncertainty (if the item was unfamiliar) and the bidding population size (the number of bidders) caused the winner’s curse to happen more frequently.⁹ Participants actually estimated the value of the items to be lower than their objective value, with the average bid being $5.13, but the mean winning bid was $10.01.¹⁰

In 2020, economists Paul R. Milgrom and Robert B. Wilson, won a Nobel Prize for their work on auction theory.¹¹ They began researching the winner’s curse in 1982, but continued to research the phenomenon and more recently developed an explanation as to why rational bidders place maximum bids below the expected value of the commodity: because they are afraid of the winner’s curse.¹¹

The winner’s curse is likely to occur in any situation where auctioning is the means through which to obtain an item. Have you ever wondered why free agents tend to get such high-paying deals, or why houses sell for way more than market value? It’s all because of the winner’s curse — the winner has to be someone who is willing to bid more than other bidders, which necessarily means that they will be paying over the objective worth of the item. This simple fact is why the winner’s curse is so hard to avoid, even if we are aware of it — not to mention that it is difficult to remain rational in a bidding situation.¹⁰

The winner’s curse demonstrates that a winning firm is not the most rational or most efficient firm. The most efficient firm would secure a commodity at a price close to its inherent value, or lower. Richard Thaler, an Economics Nobel Prize winner, noted in his article “Anomalies: The Winner’s Curse” that the existence of the winner’s curse proves that people are not rational consumers.10 While today, we are used to behavioral scientists claiming that various biases influence our decision-making skills, in the 1970s and 80s, economists still believed in the homo economicus: the purely rational decision-maker.

The winner’s curse opposes the theory of market efficiency that is used in classical economics. The market efficiency theory suggests that things are bought and sold at a fair price that matches the value of the item. However, the theory also assumes that all people have the same amount of information — and sufficient information — to make an informed prediction of the inherent value of the item. If the market efficient theory is true, then the winner’s curse cannot be true as well.

Another criticism of the winner’s curse is that it assumes that the inherent value of an item is the same for all bidders. That might hold true for situations like bidding on an oil field, when the value can be attached to the price, but not for all situations. For example, imagine there are two parties bidding on a piece of real estate for a home. One party might want to purchase the property as an investment, which means that its inherent value is correlated to the profit they could make. The other party is looking to purchase the house to start a family there, which means that the property holds a lot of emotional and difficult-to-quantify value. They might not feel like they’ve overpaid for the house even if they are willing to pay more than the other bidder or market value. The fact that an individual might place a subjective value on a commodity was a possibility brought up by Bazerman and Samuelson, but often gets forgotten when discussing the winner’s curse.⁹

Case Study: The Winner’s Curse in Sports and Television

We don’t tend to think of sports as an economic industry that is regulated by the same rules as other competitive markets. However, players, leagues, and federations get swapped and traded just as stocks do.

The sports market makes deals and trades in auction-like situations so that all parties involved have a chance of obtaining a team or player. However, the auction-like situation is particularly dangerous for sports, as it is very difficult to objectively value the worth of a federation or of a player. Bids that are made are based on past performance and value but may not accurately reflect future performance. It is the most optimistic bidder that ends up securing the entity, which means there’s a good chance the revenues they return are much lower than anticipated.¹²

Another example is TV channels that are forced to bid against one another for broadcasting rights. It is likely that each channel will make the same amount of revenue from broadcasting a game, as people are loyal to watching their teams rather than to a particular channel, suggesting it is a common value auction. Yet, the only way for a TV channel to secure the right is to bid more than their competitors, which means they have to bid more than the average channel is willing to. A similar situation happens when countries bid to host the Olympics, where essentially, they are bidding for the rights to host the event just like a TV channel hosts a game.¹²

In his 2015 paper on the winner’s curse in sports, economist Wladimir Andreff speculated that the prominence of the winner’s curse in the sports industry is due to a monopoly on the supply side, and various competitors on the demand side.¹² In the broadcasting rights scenario, there is only one game, but many channels that want to acquire the rights. When trading a player, there is only one player, but many teams want to trade for them. The asymmetry between supply and demand contributes to the likelihood of the winner’s curse, as bidders feel desperate to acquire the sporting monopoly that uses its position to inflate bids.¹²

Too Much of a Good Thing: Reciprocity and Corruption

The winner’s curse is likely to happen in an auction even without anyone unfairly knowing more information about the intrinsic value of a commodity. Its likelihood is thus exasperated when corruption occurs — if one bidder knows more information, the asymmetry of knowledge increases. Unfortunately, corruption is common in multiple areas of life: politics, sports, and business. In this article, our contributor Tony Jiang explores corruption from a behavioral science lens.

Sports Leagues Aren’t As Competitive As You Might Think

If you were interested in the positioning of the sports industry as a competitive market, you might want to check out this article. Our contributor Siddharth Ramalingam argues that the competitive balance between teams is diminishing because of money inequality. He examines the industry from a monetary perspective to explain the weakening competitive balance.

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10. Thaler, R. H. (1988). Anomalies: The Winner’s Curse”. The Journal of Economic Perspectives, 2(1), 191-202. https://www.jstor.org/stable/1942752
11. Nobel: US auction theorists win economics prize. (2020, October 12). BBC News. https://www.bbc.com/news/business-54509051
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