Note on Behavioral Economics

The “winner's curse” (or, more precisely, failure to account for the winner's curse) was one of the first behavioral “anomalies” to be discussed in the literature. The idea dates back to 1971, and was first applied to the bidding for oil drilling rights (SeeCapen, Clapp, & Campbell, 1971). The winner's curse is the phenomenon of systematically upward-biased winning bids in an auction market. That is, the winning bid in an auction tends to be much higher than some objectively defined value of the good.2The basis of the anomaly is relatively simple. In an auction with a large number of buyers, each possessing imperfect information concerning the value of the auctioned good, there will be a spread of estimated values. If buyers possess rational expectations, we will expect roughly half (assuming a symmetric distribution of estimates) of the bidders to overestimate the value of the good, and roughly half to underestimate its true value. If buyers naively bid their estimated value of the good, the winning bid will equal the most extremely over-valued estimate. Thus, the winning bid will not only be an overestimate of the good's true value, but it will be the most extreme overestimate made by any bidder. Hence, while on average an individual's bid may equal the actual value of the auctioned good, thewinningbid will most likely be a severe overestimate of the good's value. For this reason, bidders who naively bid their estimated value at an auction will tend to regret winning.