Winner's Curse

The winner's curse is the unfortunate consequence of an auction in which the winning offer for an item was bid so much higher than the item's worth that the winner cannot recover enough value to justify the price paid.

A free market can function like an auction—sellers offer their goods and buyers offer their bids of the prices they are willing to pay for those goods. [Page 2232]Bidders, though they may be sensitive to price and prefer to pay the lowest amount possible, “win” the auction when a seller accepts the highest price offered. In a free market for scarce goods, as in an auction, buyers may willingly increase their bid to maximize the likelihood of purchasing, or winning, the goods they want. One consequence of this auction-like process is that winning buyers may come to regret the high price they willingly paid, and to feel “cursed” by their inability to recover enough value to justify it.

The winning buyer paid more for the goods than any other potential buyer was willing to pay. Perhaps the winner made an error in judgment and inaccurately assessed the value. In addition to overly optimistic forecasts, such errors also may be caused by incorrect or incomplete information about the goods. These information problems may arise when sellers bluff buyers by misrepresenting the attributes of the goods. Governments may regulate commerce to criminalize untrue statements, false appearances, and misrepresentations. This government action to interfere with a free market is justified to ensure the most efficient allocation of social resources. The market forces of supply and demand better support economic efficiency when buyer-seller decision making is based on accurate information.

The winner's curse may not be due to any misrepresentation by the seller about the features of the goods. The curse may arise from an attribute of the buyer whose winning bid was higher than all other bidders in the market. Did they all have better information about the true value of the goods than the winner had? If so, then the winner indeed bid too high based on overestimating the net benefits or utility to be had from the purchase.

Calculating utility, however, is a cost-benefit analysis, and it is often extremely difficult to do it with precision and accuracy. One important cause of such poor analyses is that the benefits are not all measured in the same units as costs, or may not be possible to quantify at all. How does one put a precise value, for example, on the pride or joy of ownership?

In addition, utility and benefits are just forecasts at the time of purchase. The purchase costs, however, must typically be committed before the benefits can be realized. The magnitude of the benefit actually realized may be less than the anticipated forecast. In short, for the winner, utility is a subjective judgment of value in an uncertain future. The winner may feel cursed by regrets if that future does not meet the relatively high expectations.

The winner is the buyer who forecast more optimistically about the future than any other bidder, but that buyer may not be likely to comprehend the error in a society characterized by closely held information and deficiencies in the distribution of knowledge about prices. Thus, the winner's curse is more likely to be observed in open societies where buyers have access to broad economic knowledge. Interestingly, such societies tend to have more productive economies that, over the long term, efficiently increase the supply of goods and drive down prices. Over the long term, one would expect that human nature would become increasingly sensitive to the winner's curse in an economy becoming more efficient—overpaying when prices are declining seems that much more unfair. In this context, the winner's curse can be viewed as the buyer's perception that distributive justice has been violated by the terms of the buyer-seller exchange.

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