Suppose you have a jar of coins and ask several friends to bid on the jar. The highest bid will be deemed the winner. According to Richard H. Thaler ( “Anomalies: The Winner’s Curse published in The Journal of Economic Perspectives ( Volume 2, Issue 1)(Winter 1988) at pp. 191-202), (Thaler ) two results will occur: “(1) the average bid will be significantly less than the value of the coins (bidders are risk adverse); (2) the winning bid will exceed the value of the jar”. This is known as the “winner’s curse”. (Id. at 192.)
The concept of the winner’s curse was first written about by three Atlantic Richfield engineers, Capen, Clapp and Campbell (1971) in connection with the purchase of oil drilling rights on particular parcels of land. The rights were auctioned off. Given the fact that it was difficult to estimate exactly how much oil was in a given location, the bids ranged from very high to very low. But, what often occurred is that the “winner” was most likely a “loser”. It was “cursed” in one of two ways: “(1) the winning bid exceed[ed] the value of the tract, so the firm [lost] money; or (2) the value of the tract [was] less than the expert’s estimate so the winning firm is disappointed.” (Id. at 192.)
This concept while often applied to auctions may occur in any type of negotiation in which it is possible to “overbid”. One example is the purchase of a used automobile. Most potential buyers approach a used car with skepticism and use the apt strategy of under bidding: their intuition tells them to bid low and to be ready to walk away because chances are the seller knows more than they do about the vehicle. Otherwise, it would not be for sale “at such a great price”! (“Identifying the Winner’s Curse in Negotiation", Program on Negotiation at Harvard Law School, March 5, 2013 blog)
This is precisely the strategy recommended for thwarting the “winner’s curse: assume you have overestimated the price and lower your bid from your original bid. If your original bid was, indeed, too much, your lowered bid will actually, then, be more in line with the true value of the item. (“The Bidding Game”, Beyond Discovery at p.6).
As the Harvard Negotiation blog points out, the winner’s curse occurs because; “… your gains depends on the other side’s acceptance; and the other side knows more than you do.” (Id.). That is, while it is best to offer zero or close to it, most people will offer much more (i.e., over estimate) since winning depends on the acceptance of the bid by others. Further, more often than not, the seller is better informed than you, the buyer, about the commodity being offered. Typically, when you bid on an item you know little about, you become even more uncertain. And just as typically, your bid will be accepted only when it exceeds the value of the commodity at issue. That is, you have over bargained and over paid due to a lack of knowledge of the true value of the item! (“Identifying the Winner’s Curse in Negotiation” at 1.).
So, the morale is to be skeptical. When bidding on the unknown, under estimate the value and do not get caught up in the bidding frenzy!
…. Just something to think about!