The Winner’s Curse
In our discussions of auctions and auction theory, we determined and analyzed the best bidding strategies that a buyer should use. The best strategies, however, weren’t the strategies that ensured a winning bid for the buyer. The best strategy for a buyer accounts for his own valuation of the object in question and gives him his best chance of winning by still maintaining a payoff if he were to win.
However, in an attempt to apply these theories to real life, we should consider how people’s emotions affect the process of bidding in auctions. One instance of this is a pattern called ‘The Winner’s Curse’.
The winner’s curse is the idea that the winner of an auction will typically overpay, simply because the winner of an auction tends to be the bidder who overestimates the value of the object. Considering that a strategic bid is based upon a bidder’s true value, if a bidder has the highest value his bid will typically be the highest. This phenomenon especially presents itself in common value auctions where the majority of bidders have a similar value for the object in question. Therefore it seems likely the winning bid will overestimate the value of the object, and the winner will not have a significant payoff or any at all.
Winner’s Curse can be avoided in most auction settings, but can also be prevented through bid shaving, the practice of bidding a lower amount to account for risk of overpaying.
These ideas and methodologies are elaborated in this article: http://mindyourdecisions.com/blog/2008/11/18/understanding-the-winner%E2%80%99s-curse/