Winner's Curse Explained

With respect to an auction, I believe we used the word fate before the term winner's curse was established. Almost every common value auction has a victim of the winner's curse. This term first came into existence in the second half of the 20th century, when oil companies were bidding for offshore oil fields. The oil companies who won the auctions by bidding aggressively, ultimately realized that they had overestimated the value of the offshore oil fields, thus they had made a loss even after winning the auction. A common example of winner's curse is, when a bidder overestimates the value of a car in a luxury car auction, and ends up buying the car for a higher price. It can be stated that, the winner's curse often leads to a paradoxical situation, where a win leads to a loss!

What is Winner's Curse?

In common value auctions, every bidder has an estimate of the value of the good being auctioned, but he does not know the exact market value of the good. The ignorance about the market value makes the bidder overestimate the intrinsic value of the object. The bidder with the highest overestimation wins the auction hands down, but his victory is accompanied by a loss, as the highest bidder has overpaid for the good. Let us consider the following examples to understand the winner's curse:

The Envelope
A, B and C are 3 people who are bidding for an envelope. They were told that the envelope contains money. Finally, after observing, the envelope A, B and C bid, $10, $50, and $1, respectively. B won the auction as he was the highest bidder, and he opened the envelope just to realize that it contained a $1 bill! You can easily calculate the loss that B made, he was a victim of the winner's curse.

The Coin
A, B and C went for another auction. This time a very old coin was up for grabs. Once they were done observing the coin, they were asked to bid. This time, A and C bid $50 and $100 respectively, but B bid $500! The coin now belonged to B. A and C were sure that B was a victim of the winner's curse once again, but they did not know that B had contacts in an antique market outside the country, where the coin would fetch over $2000!

The Explanation

The first example clearly depicts the winner's curse in a common value auction where the bidders have incomplete information, while the second case shows how it can be avoided if you possess complete information. You can easily infer from the above examples that, you can avoid winner's curse if you have complete information about the valuation of the good being auctioned.

One thing that you should remember is, the value of a particular good is very subjective. Something that is priceless for you may be worthless for someone else. When your bid is driven by emotion rather than the need for monetary gains, you are immune to the winner's curse! Thus, private value auctions are not affected by winner's curse.

A way to avoid the winner's curse even in the state of incomplete information, is to bid less than the value that you estimate (this technique is often used by intelligent bidders all over the world). By using this method, you reduce the chance of overestimating. It is also believed that the probability of overestimation increases with the number of the bidders, as, if one bidder overestimates, the others tend to follow.

Winner's curse is not a very bad thing, it is a inseparable part of auctions, so do not lose hope if you are a victim of this curse once. You will surely learn from your mistakes, and improve with experience that you gain at each auction.