Business Life: The bidder’s curse

29th August, 2008

Armed with a jar full of coins and an attentive audience, economists have long known a reliable way to raise some beer money: offer to give the coins – or their cash value in a more convenient form – to whoever bids the most for them. The winner will almost always overbid, often by a hefty margin.
This isn’t because human beings are naturally incompetent at the task of guessing the number of coins in a jar. Most people do it rather well, and the average bid is usually a bit lower than the value of the prize. Fortunately for the auctioneer, auctions do not close with the average bid, but when all but one bidder has given up. It only takes a couple of mistaken bidders to generate a fat profit for the seller.
Economists call this “the winner’s curse”. It was discovered by three rueful petroleum engineers who had observed the tendency of oil companies to overbid for licences to drill in Alaska in the 1960s.
The winner’s curse is nothing to do with getting carried away in the heat of the moment. It simply reflects the fact that when a prize’s true value is unknown – be it a commercial property, an oil licence or a jar of coins – most bidders do not adjust for the fact that auctions select whoever has the most optimistic estimate.
Of course, getting carried away is also a risk of bidding in an auction, and thanks to a curious feature of the online auction site, eBay, it is now possible to catch people in the act of doing just that. Because eBay allows sellers to make fixed price, take-it-or-leave-it offers as well as to auction products, there is a clear symptom of irrational exuberance: whenever an auction bidder offers to pay more than he could have got through a simple search on the same website, he is clearly getting over-excited.
The economists Young Han Lee and Ulrike Malmendier recently realised this and decided to look closely at eBay auctions of a particular product, a popular board game. Over-exuberant bidding was astonishingly common: in nearly three quarters of cases they examined, the winning bidder paid more (after shipping) than he could have paid in a fixed-price sale. This is despite the fact that the quality of the auctioned goods was no higher and the reputation of the auction sellers was typically lower.
Most bidders, admittedly, were much more sensible. A small minority were responsible for bidding up the auction prices to irrational levels; that, happily for the sellers, was all that was needed.

First published, Business Life Magazine, May 2008

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