The winner’s curse is a phenomenon that may occur in common value auctions with incomplete information. In short, the winner’s curse says that in such an auction, the winner will tend to overpay.
The winner may overpay or be “cursed” in one of two ways:
1) the winning bid exceeds the value of the auctioned asset such that the winner is worse off in absolute terms; or 2) the value of the asset is less than the bidder anticipated, so the bidder may still have a net gain but will be worse off than anticipated.
However, an actual over payment will generally occur only if the winner fails to account for the winner’s curse when bidding (an outcome that, according to the revenue equivalence theorem, need never occur).
In a common value auction, the auctioned item is of roughly equal value to all bidders, but the bidders don’t know the item’s market value when they bid. Each player independently estimates the value of the item before bidding.
The winner of an auction is the bidder who submits the highest bid. Since the auctioned item is worth roughly the same to all bidders, they are distinguished only by their respective estimates of the market value. The winner, then, is the bidder making the highest estimate. If we assume that the average bid is accurate, then the highest bidder overestimates the item’s value. Thus, the auction’s winner is likely to overpay.
More formally, this result is obtained using conditional expectation. We are interested in a bidder’s expected value from the auction (the expected value of the item, minus the expected price) conditioned on the assumption that the bidder wins the auction. It turns out that for a bidder’s true estimate the expected value is negative, meaning that on average the winning bidder is overpaying.
Savvy bidders will avoid the winner’s curse by bid shading, or placing a bid that is below their ex ante estimation of the value of the item for sale — but equal to their ex post belief about the value of the item, given that they win the auction. The key point is that winning the auction is bad news about the value of the item for the winner. It means that he or she was the most optimistic and, if bidders are correct in their estimations on average, that too much was paid. Therefore savvy bidders revise their ex ante estimations downwards to take account of this effect.
Since most auctions involve at least some amount of common value, and some degree of uncertainty about that common value, the winner’s curse is an important phenomenon.
So if, for example, an oil field had an actual intrinsic value of $10 million, oil companies might guess its value to be anywhere from $5 million to $20 million. The company who wrongly estimated at $20 million and placed a bid at that level would win the auction, and later find that it was not worth as much.
Other auctions where the winner’s curse is significant:
- Spectrum auctions in which companies bid on licenses to use portions of the electromagnetic spectrum. Here, the uncertainty would come from, for example, estimating the value of the cell phone market in City. Normally as we have seen in India, Online auction winners have to pay humungous amuont of money to win the spectrum and their ROE is a big challenge for these companies…E.g. Idea, Bharti Airtel, Vodafone who bid for recent auctions.Bidding wars for cellphone frequencies drive telecom companies to the brink of bankruptcy.
- Initial public offerings (IPO), in which bidders need to estimate what the market value of a company’s stock will be.IPOs are also examples similar to auctions. And, when companies buy other companies – the infamous mergers and acquisitions – the winner’s curse is present more often than not. Astoundingly, more than half of all acquisitions destroy value, according to a McKinsey study.
- Pay per click advertising online, in which advertisers gain higher ranking if they bid higher amounts per click from a search engine user.
The Winner’s curse suggests that the winner of an auction often turns out to be the loser. Industry analysts have noted that companies that regularly emerged as winning bidders from these oilfields auctions systematically paid too much, and years later went under. This is understandable…The highest bid at an auction is often much too high – unless these bidders have critical information other aren’t privy to.
So why do we fall victim to the winner’s curse? First, the real value of many things is uncertain. Additionally, the more interested parties, the greater the likelihood of an overly enthusiastic bid. Second, we want to outdo competitors.
According to great Charlie Munger, open-outcry auctions are a perfect set up for driving people to highly irrational behavior. Auction is a place where multiple psychological biases act together, creating a lollapalooza effect, and results in a series of bad decisions.