Optimists win sealed-bid auctions

November 26, 2012 - 06:29

But optimism doesn’t always pay off. The winner can end up a loser.

Winners of sealed-bid auctions can find themselves paying more for something than it was really worth. (Photo: Colourbox)

Participants in a sealed bid auction can only make one bid. To win, this bid must be higher than all competitors’ bids on the first try – without anyone knowing how much the others were bidding.

“Many have a tendency to bid too high. This can turn a winner into a loser, as the winner may be paying more for something than it’s worth,” says Joachim Ahlberg of Örebro University.

Ahlberg examined this issue for his doctoral degree in community economy.

Sealed bid or sealed tender auctions are common in public tenders, such as when authorities grant licenses to radio channels or mobile phone operators.

Winner’s Curse

Ahlberg refers to the effect as the winner’s curse.

The situation arises when whatever is for sale has an equal value for all the potential buyers, but they cannot be certain what the real market value is. An example is when operators bid on oil-drilling rights: The value of the contract for all the oil companies pivots on what they can sell the oil for – but future oil prices are uncertain.

Joachim Ahlberg (Photo: Karin Fjell)

The winner of the drilling contract is generally whoever is most optimistic about the future of oil prices, but for the winner to be right, all the competitors had to be off the mark in their prognoses.

Studying real behaviour

Economic theory hinges on the idea that people behave completely rationally.

This would mean that the winner of the auction could have an overly optimistic estimate of the value and in future tenders would adjust bids downward to some extent.

But theory isn’t always reflected in reality. A special branch of community economics, called behavioural economy, has developed to deal with decisions people make in real life, rather than what they should do according to theory.

Several thousand units simultaneously

Ahlberg set up an experiment with real people to see how they behave. His conclusion − that people bid too high −is based on a comparison of experimental results with economic theory.

Ahlberg names the European cap-and-trade (carbon emissions quotas) market, electrical power bourses and government bonds markets as examples of auctions for which his results apply.

Nils-Henrik von der Fehr (Photo: UiO)

A common denominator for all of these bidding situations is they all offer more than a single unit for sale − in fact, several thousand units are sold simultaneously. Even if you win the auction, it only means you get to buy the most units, not that you get to buy them all.

Sceptical

Nils-Henrik von der Fehr, a professor in the Department of Economics at the University of Oslo, is sceptical of Ahlberg's analysis.

“Generally, the design of an auction means fairly little,” he says.

Ahlberg's experiment contains an element of uncertainty. Corporations spend enormous resources calculating how much to bid and have a lot of experience on which to draw. The professor thinks it’s hard to recreate a realistic scenario in an experiment.

Another factor is the magnitude of the competition. "When there is a great deal of competition, the individual player has little influence on the price,” says Von der Fehr.

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Read the Norwegian version of this article at forskning.no

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Translated by
Glenn Ostling

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