#2 Behavioral Economics & Auctions
By: Samparna Tripathy
Tags: Decision Making, Behavioral Economics, Auction, Auction Theory

Winner’s Curse:

A phenomenon in which the bidder with the most optimistic valuation of product wins the auctions and ends up overpaying — thus feeling a sense of regret

The asset put up for auction can have a “private value” or a “common value” or both. Take the example of a 19th century Van Gogh painting of “Starry Nights” in your grandfather’s chamber. In the art markets, there would be a certain value for this painting (primarily dependent on how much it could resell for). This is a “common value” derived from what prospective buyers are willing to pay for it factoring commonly known characteristics of the auctioned object. However, consider the personal value you may associate with this painting — it may be symbolic of your memories of your grandfather and the value you associate with it is private to you and independent of the market. This is a “private value” that is primarily unknown to other buyers. So, imagine a bidder quotes a very high bid in this art auction. Other potential bidders would constantly be in a quagmire whether the inflated bid is a result of a “private value” (in which case they could bow out) or a “common value” (in which case it could indicate that they didn’t have adequate information on product quality to value it correctly and may encourage to stay longer & bid more).

Especially in common value environments (such as auctions for mining a particular patch of land), the winner may be the one with the largest positive error in valuing the product and may end up losing money. The extent to which bidders anticipate “the winner’s curse” influences the caution with which bids are placed. This is the reason independent assessments on the value of the underlying resources (such as the mining reserves) can help bidders to overcome the fear of the “winner’s curse” and bid rationally.

For example: in open English auctions (where the asking bid price is raised from low to high until the reserve price is met), bidders are aware of the competing bids and are constantly updating their valuation. So bidders recognize that risk of feeling that regret may be lower. However, in open Dutch auctions (where the asking bid price is reduced from high to low until the reserve price is met), it is possible that the bidder battles between the risk of overbidding and that of potentially losing out the item.

The impact of the “winner’s curse” has been seen in the differential value realized in second price, sealed bid auctions vs first price, sealed bid auctions. In any sealed bids, the bidders are almost blind to the competing valuations of the product. In first price, sealed bid auctions — the winner needs to pay the price he quoted (which may be much higher than the second price and that differential could have costed the opportunity to make profits from the deal). Hence, bidders are generally more conservative in quotes. However, in second price, sealed bid auctions — the winners are assured of paying the price of the second highest bid. This raises the confidence to quote high bids, thus realizing better values for the product auctioned.

Competitive Arousal

A phenomenon in which the motivation for bidder moves away from making the best decision to winning at any cost

According to the competitive arousal theory, intensifying the competitive situation can motivate bidders to overbid so as to win the competition, even if doing so is costly. Such arousal can be experienced in case of heightened rivalries (especially between two bidding parties) and may trigger a “bidding war”. As long as there is clarity that winning a bid can annihilate the competition and prove advantageous to the bidder in the long term, placing a bid higher than the fair value may make sense. However, if competitive arousal takes over, then the bidder may fall prey to personal animosities and may take a rash decision. Other factors that can heighten this “competitive arousal” are time pressures (ex: the timer on online auctions & the shout of the Going One, Going Twice) and the presence of a spotlight (ex: highly engaged audience in live auctions). Parties that recognize the risks of irrational decision making prepare accordingly to mitigate competitive arousal and instead pick & choose the contests to win.