Imagine you own one of the world’s biggest offshore drilling companies. You fly to Texas, USA to take part in an auction with 2 other bidder companies, courting the drilling rights for an oil field in that state. After accounting for all drilling-related costs and potential revenue streams, the intrinsic value of the drilling rights comes to $10 million. . The other two companies bid $12 million and $18 million, while you win the auction with your bid offering $22 million. But have you really won? Not really if you think. You ended up paying 120% more than what that oil field was really worth. But here’s the catch. Even if you were 100% sure that your bidding price is too high, you would still have done nothing about it, as the highest bid always wins the auction, no matter how overpriced the bid may be. This paradoxical phenomenon, popularly known as the winner’s curse has been playing the cards in the world of auctions and negotiations for long now.

Paul Milgrom of Stanford University, a leading auction scholar, in his book Putting Auction Theory precisely refers to the winners curse as a selection bias that arises because a bidder tends to win more often when his value estimate is too high than when it is too low. The occurrence of this phenomenon is widely observed not only in the auctions of low priced value whose bidders are perceived to be amateurs but also in high valued auctions where even the big companies fall prey.

The term winners curse was originally coined when a group of companies were bidding for offshore oil drilling rights in the Gulf of Mexico. The early 1970s witnessed a large number of US oiling companies collapsing shortly after winning the auctioned drilling rights in several places in the USA, eventually leading to bankruptcy of some. Turns out the true value of the drilling rights was much less than what the geologists and the economists hired by these companies had estimated.

Image source: Google images

But what really triggers this curse? The human brain works in a pretty competitive way and the reason can be probed at the very core of cognitive science. Is emotional friction or cognitive psychology pulling the strings here? I’d say both! Let’s discuss why cognitive first: In a typical auction, the participants would try to assess the value of the item on auction accurately to the best of their capacity. The value of the initial bid submitted by the participants would depend on the level of competition. Fiercer the completion, closer the bids would be to the value determined by the participant. This is because the higher the number of bidders in the auction, the higher chances that someone will outbid you develops. A large number of bidders allow us to safely suppose that the average of the independent assessed values of the item on auction would be quite close to the true value of the item. This means that the winner of the auction has offered to pay more than the average bid and ultimately way more than the true value. In other words, the participants will simply fail to realize that in order to submit a winning bid, they valuing the auctioned item way higher than everyone else and hence most likely overvalue it in respect of it’s true value.

The emotional aspect leading to the winners curse is driven largely by auction fever; an uncontrollable desire to win the auction.  In 2005, the NFL (National Football League) auctioned off the rights to broadcast Monday Night Football.  ESPN won the auction offering to pay 1.1 billion dollars for the broadcasting rights over eight years, almost twice than what ABC was previously paying. Whether ESPN saw potential cash inflows that other bidder didn’t or it simply ended up overpaying, winner’s curse did affect this auction.

Some other causes like incomplete information, rumors and subjective factors that have a strong influence on the bidder can also be attributed to the gap between auctioned and intrinsic values. Incomplete information or as economics knows it, asymmetric information is one of the two reasons why the winner’s curse is often called a trap, the other being that your gains are entirely dependent upon other persons acceptance which is most likely to occur in situation favorable to the seller and unfavorable to the bidder. Asymmetric information would give rise to lemon problem-a problems that arise regarding the value of an investment due to unequal amount of information possessed by the seller and buyer. The bids for an item on auction about which the bidder knows little often heightens uncertainty and decreases the return from the transaction dramatically for the bidder.

Winner’s curse is a comprehensive phenomenon in itself. It can happen in any market where auctions take place. In the investing world, it commonly applies to initial public offerings (IPOs). When a company first steps into the market to raise funds through issue of shares, insiders like promoters, family, early investors- angel capitalist, venture capitalist etc are selling their stakes to the public. They have in depth knowledge about the company and its operations, managements, growth potential amongst other key areas of performance. They have an accurate idea about the intrinsic value of the shares. The potential shareholders on the other hand may or may not be completely informed about the company; resultantly they’re unable to estimate the intrinsic value of the shares. The uniformed investors usually fall prey to winner’s curse as they tend to subscribe to every IPO in comparison to informed investors who only buy new shares if the issue price is less than the fair value.

Winners curse also occurs when the bidders underestimate the magnitude of the adjustment necessary to compensate for the presence of other bidders. This is what exactly happens in the M&A market. If you think of an acquisition as a result of an auction, by now you probably will understand why acquirers tend to overpay. The winning bid routinely overestimates the benefits that are to accrue due to competitive pressure. One has to look at the projected ‘synergistic benefits’ at the time of benefits and the actual results a couple of years down the line. The acquirers often fail to take into consideration (which they really should!) the “anti synergies” that are bound emerge on meshing the two firms together. The losses and the costs incurred in order to achieve some real synergies that may exist, often takes a toll on the profits of the company and ultimately shareholders are the one who are at the receiving end of the winner’s curse.

An important question to ponder is that does the winner’s curse exist in all auctions?  Well, no. Many auctions are immune from the winner’s curse. An interesting example is auctions where bidders have an independent private value for the item on sale i.e. the prize has an intrinsic value that is different to each customer and not of a common value to everyone. An eBay auction is the ideal example. The $15 Iron man’s action figure up for an auction sale on eBay has a different value to each customer. It may be worth $100 to one and not more than $5 to another. The values are completely individual and dependent one’s own preferences. In order to avoid overpaying in such auctions, all you need to do is set a maximum bid less than your individual estimation of worth. The winner most likely gets the item at a price below his individual value and the winner’s curse should never happen.

Auctions pervade our markets. All of them! In order to avoid becoming the next victim of the winner’s curse, one must analyze if the asset on auction possesses an element of common value, if so bid with caution! One must also evaluate their financial ability and do a cost benefit analysis before placing each bid. The key lies in the answer to the question, is it really worth it?

Written By- Neha Haldia

Neha Haldia is a 3nd year, B.com Hons. student at SRCC.

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