Does the fear of overpaying for an item at auction stop you from bidding? There are ways to skip the Winner’s Curse.
What’s the winner’s curse? Imagine you are participating in an auction selling a jar of coins. The jar clearly has value—after all, it contains currency. But, how do you determine the amount of your bid when you don’t know the real value of the jar yet?
This situation happens every day in auctions selling almost any type of asset using competitive bidding. As a buyer, you want to get a deal, or at minimum, pay what it’s worth. But since the worth is generally unknown at this point, and you have to commit to a bid, there is a possibility you could end up overestimating the item’s worth and overpaying. This is what some call the “winner’s curse.”
Last week, two Stanford University economists, Paul R. Milgrom and Robert B. Wilson, were awarded the 2020 Nobel Economics prize for their study of the auction method, including their explanation of this so-called “winner’s curse” and how bidders seek to avoid it.
The winner’s curse places the bidder in a tough position. On one hand, you want to outbid the others in order to win the item. On the other hand, to win the item, you have to be willing to pay the most out of everyone else. And this may cause you to ask the questions, “Why did I place more value on the item than everyone else did? Do they know something I don’t?”
Know “common value” versus “private value”
Common value, also known as market value, is when the value of an item is deemed to be the same for everyone. Private value is when the perceived value of an item differs from bidder to bidder.
For example, your grandmother’s old cookbook containing family recipes could be perceived by you as “priceless.” This would be the private value. However, to the rest of the world who may not share the same sentiment for your family’s recipes, this cookbook could only be worth a few dollars. This would be the common value.
The value of an item/service is determined by what someone is willing to pay for it. The auction method makes it a goal to find the person who values the item most—thus, being willing to pay more for it than anyone else.
So how do you avoid getting that “winner’s curse” feeling that you overpaid?
An article from Harvard Law School’s Program on Negotiation breaks it down into three principles.
Determine what kind of asset is being auctioned
First, determine whether the asset is a private-value asset or a common-value asset. If the asset has private value to you, you don’t need to worry about the winner’s curse. Whatever you needed to bid in order to gain possession of your grandmother’s old recipe book would seem appropriate for how much you care about it.
However, a common-value asset should have roughly equal value to all bidders, even if the true value is uncertain at this point (i.e. the jar of coins)
Figure out if you have an “edge”
Do you have a “comparative advantage” over the other bidders? This could be anything from unique knowledge, capabilities or resources. What makes this item more unique to you, therefore making it more valuable to you?
This is where common value can overlap with private value. If the item actually means more to you than others, winner’s curse is a non-issue.
Look forward and reason back
Before you make a bid, consider how you’ll feel if you end up with the winning bid. Ask yourself, “Would I feel comfortable making this bid if I knew that the other bidders value the asset less than I do?”
If your answer is yes, then absolutely proceed. If it’s no, perhaps set a specific budget for what you are willing to spend. When the bids exceed that amount, you know that you would be overspending according to your standard.
So, now that you know about the winner’s curse, how does that affect your bid on that jar of coins? Perhaps you’ll devise a secret way of calculating the value of the currency inside. Or maybe you know that the jar contains valuable antique coins that other bidders overlooked. Does having this knowledge make you bid more conservatively, or does it make you realize the value even more?