## The Winner’s Curse in Acquisition

The winner’s curse is an interesting anomaly in economics. When people participate in a common value auction without knowing others’ value on the object, they each estimate the value and bid accordingly. If we assume that the true value of the object is close to the average bid, then the winning bids are always higher than the true value of the item. The winner has ultimately overestimated the value of the object and will have to overpay.

Richard H. Thaler’s article, “Anomalies: The Winner’s Curse,” describes an interesting experiment that demonstrates how the winner’s curse can occur. Let us suppose there are two companies: Company A and Company B. Company A is trying to acquire Company B but does not know the value of the Company B yet. After an oil exploration project, the value of Company B will be determined but it will not be revealed to Company A. In other words, Company A will have to estimate the value of Company B and submit a bid. In the worst case, the value will be \$0/share, and in the best case, it will be \$100/share. Company B is equally likely to be in any range of these two values.

Also, Company B is valued differently: for Company A, Company B is worth 50% more than it is worth to Company B. The table below shows examples of how Company B is valued.

How much is Company B Worth?

 Company A 0 75 150 Company B 0 50 100

Company B will know its true value per share when deciding whether to accept an offer or not, and it will accept any offers that are greater than or equal to its value under current management (company B). How much should Company B offer per share?

A typical subject calculates the expected value of Company B, which is \$50, and determines its value to Company A, which is \$75, and decides it is best for Company A to bid anywhere between \$50 and \$75. This approach is wrong, however. Let us suppose Company A chooses to bid at \$60. Since Company B will accept any offers greater than equal to its true value, it will accept the offer only if its true value is between \$0 and \$60. In other words, if Company B accepts the offer, then its true value will be \$30 on average. Even if the company is worth 50% more to Company A, the value would still only be \$45, which is significantly lower than \$60. This method works not only for \$60 but for every value between \$0 and \$100. Because of the winner’s curse, the best strategy for Company A is to not bid at all.

Some economists argue that this error could be fixed with repeated experiments, but when Weiner, Bazerman, and Carroll investigated this, subjects did not improve their outcomes even after repeating the experiment for 20 times. Only 5 out of 69 learned to shade their bids at the end.

This experiment, along with what we learned in class about the winner’s curse, seems to suggest that it is not too easy to avoid the winner’s curse. In fact, the winner’s curse has been prevalent in the petroleum industry where different oil companies bid for drilling rights and the value they get out of those rights significantly exceeds the prices they have paid.

When people bid higher than the actual value of an object, are they making mistakes? In economics, people are assumed to be rational, not necessarily proven to be rational, so that explanation is still a possible answer to how this phenomenon. When faced with the winner’s curse, what should bidders do? The best strategy, as demonstrated above and talked about in class, is to not bid at all. However, not getting the object at all might not be the best strategy for a company, especially if it needs that item. In this case, a company can possibly present this idea of winner’s curse to other bidders and hopefully convince them to bid lower than they would without knowing about the winner’s curse.

Richard H. Thaler