Winner’s Curse
Winner’s curse is a concept that was mentioned in class that states that the winners often lose even when they ironically win the auction. In a paper titled “Anomalies, The Winner’s Curse” by Richard Thaler, it is not easy for bidders to overcome the winner’s curse; doing so would require considering two seemingly opposite approaches: one must bid aggressively in order to have a chance at winning in a high stake auction but at the increased risk of overbidding the true value of the item. One must also consider the expected value conditioned on winning the auction. The paper describes a scenario where it seems counter intuitive to not bid at all.
In summary, Company A is trying to buy Company B. It does not know the value of the current company but under new management, it will be worth 150% more. A seemingly reasonable approach is to assume that the company will bid somewhere between 1/2 max value, the assumed average value because of uniform distribution, to 3/4 value, the value that B would be under new leadership. What it fails to realize however, that bidding anything at all will likely yield negative results because for A to win the bid, B’s value must have been equal to or less than A’s bid, averaged to around 1/2A’s bid, only to increase to 3/4 A’s bid value under new leadership, which is less than what they pay for. So in this scenario, it is almost always true that company A cannot profit from this transaction, an extreme version of the winner’s curse. Under rational behavior, the most optimal strategies are often the safest or more passive ones and this relates back to the prisoner’s dilemna, where one can receive a huge reward despite an even larger risk.
http://faculty.chicagobooth.edu/Richard.Thaler/research/pdf/the%20winner%27s%20curse.pdf