Optimal Bidding Strategies at Auctions
Source: https://gbr.pepperdine.edu/2010/08/the-winners-curse-and-optimal-auction-bidding-strategies/
This article focuses on optimal bidding strategies at auctions using the common value model, in which the value is approximately the same for all bidders (as opposed to the independent private values model, in which the value is different for all bidders). It discusses how bidding strategies are complicated by a variety of factors, but simulation studies can use random sampling to find expected profit from different “hedging” strategies. “Hedging” refers to bidding a percentage less than one’s original value in order to optimize the balance between risk and reward. Studies show that if both bidders hedge their bids by 0%, the expected profit for the winner is actually a huge loss – this is referred to as the “Winner’s Curse,” in which the winner of the auction pays more than the object’s value and actually loses money. Studies suggest that in order to avoid this “curse” and maximize profit, bidders should hedge between 20 and 40 percent (or bid between 60 and 80 percent of their original value). For a situation with two rational bidders, the Nash Equilibrium Strategy is for each person to hedge at 30 percent, and this framework can be used to calculate strategies for auctions with n number of bidders.
These strategies use game theory to find optimal balance between risk and reward, as do the strategies for other types of auctions like Dutch, English, and Second Price. However, the strategies for English and Second Price are much more straightforward. For an English auction, in which there is an ascending bid, the bidder stays in until their value is reached and then drops out. For a Second Price auction, the payoff is the maximum of others’ bids if the bidder bids more than all the others. For each of these auctions, the bidders’ dominant strategy, which they should use every time, is to bid at their value – no more and no less. This ensures that the bidder does not fall victim to the “Winner’s Curse,” and does not pay more than the object is worth. A bidder’s decision in these two types of auctions does not depend on what the other bidders are doing, while at First Price auctions, the amount of bidders and the distribution of others’ values do play a role in influencing the bidder’s best strategy. If a bidder hedges their original value in this kind of auction, they have the opportunity to make a greater profit, although engaging in a First Price auction requires much more thought and consideration than the two previously described.