Imagine you are on a holiday in Mysore, and you want to buy a nice sandalwood elephant as a gift for your boss back home.
You go into a shop and find a beautiful looking carved sandalwood elephant priced at Rs950. After examining the piece, you conclude that if you could get it for Rs750, you would be happy with your purchase.
Just to see if the shopkeeper would go any lower on the price, you make him an offer of Rs700. Without wasting any time, the shopkeeper agrees to the Rs700 offer price, wraps the gift, hands it to you with a smile on his face, and sends you on your way.
How would you feel about the transaction? Would you have an uneasy feeling that you just got a bad deal? Despite initially feeling that Rs750 was a good bargain price, why do you feel unhappy with the purchase at Rs700?
It happens because of a phenomenon labelled by economic psychologists as “the winner’s curse”. The problem is simple: Whenever you have incomplete information, and are forced to estimate the value of an item in order to make an offer to buy it, the very acceptance of the offer signifies that you overestimated the true value of the item.
There are two conditions under which the effect of the winner’s curse becomes significant. First, if the seller has more information on the value of the product than you do, and second, if you happen to be in a bidding war with others.
When there is information asymmetry, such that the seller of the item has more information on the value of the target item than the buyer does, the very acceptance of a buyer’s offer suggests that the item’s value is less than the buyer’s offer price. This is what leads to the buyer’s feeling of discomfort when an offer is readily accepted by the seller.
When there are many people bidding for an item with an uncertain value, the problem is worse. Economically, it is reasonable to assume that the “real” value of the item is not more than the average of all the bids being placed on the item. However, the “winner” of the auction is essentially the person who has estimated the highest value for the item out of all the bidders he goes up against. This suggests that the winner of a contested auction almost always overpays for the item they purchase. This creates a strange paradox in the sense that winning an auction implies not getting a good deal. As comedian Groucho Marx once said: “I don’t care to belong to a club that accepts people like me as members.”
The winner’s curse could affect us in a variety of situations. If not in a personal auction or a bidding war for a company, it could come into play when two or more companies are vying to hire the same person. If the two companies get into making competitive offers to attract the candidate, the “winning” company could end up paying more than the fair market salary to the new hire.
It also works in reverse when bidding on projects. The winner of an open bidding process is most likely the one who has most underestimated the costs of completing the project. If that low bid is not justified by comparable efficiencies unique to the bidder, the lowest bid is putting itself at considerable risk.
So, what do you do to minimize the impact of the winner’s curse? The easiest way to avoid the winner’s curse is to try and get more information to form an independent assessment of a target’s true value to you.
As we discussed, the effect of this curse is enhanced when the two parties to the transaction have an information differential. If you can get additional information on the “true value” of the item, you will be less likely to overbid and lose money by winning the auction. This may involve hiring consultants or experts who can give you more realistic estimates on the value of the product.
In auction settings, a second strategy used by savvy bidders is to use “bid shading”, a process by which you bid only up to a level that is a little lower than your estimated value of the product.
Another strategy is simply to take on the perspective of the others involved in the bidding. Put yourself in the shoes of the other bidders and think about how they are looking at this auction.
Is it possible that the target object may be of more value to them than it is to you?
If yes, then there is no point in trying to outbid your opponent because even if you win the bid, you would have paid more than what it was worth to your opponent (and worth considerably less to you).
The moral is simple: Keep in mind the reason why you want to win, and what the true value of that victory is for you. If the cost of winning is more than the value of the thing you win, you will stand to lose even in your victory.
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Praveen Aggarwal is an associate professor of marketing at the Labovitz School of Business and Economics at the University of Minnesota Duluth and Rajiv Vaidyanathan is a professor of marketing and director of MBA programmes at the University of Minnesota Duluth.