‘Winner’s Curse’ and the theory of auctions

How many of us remember Tymal Mills? Not many, I’m afraid. Ahead of the 2017 edition of the Indian Premier League, Royal Challengers Bangalore (RCB) was looking desperately for a bowler to take the place of Mitchell Starc who had pulled out of the tournament. RCB bought the English seamer Tymal Mills for a whopping sum of Rs 12 crore in the auction. Mills played only five matches and picked up five wickets at an average of 8.57 runs per over. For Mills, this was the first and last season in IPL.

Circa 2007. A consortium led by Royal Bank of Scotland (RBS) took over ABN Amro in a fierce M&A battle with its rival Barclays Bank in October 2007, paying 49.2 billion sterling pounds, mostly in cash. The British government had to later bail out RBS as it had exhausted its reserves to fund the takeover. It was estimated that the winning bid was equal to the combined market value of Citibank, Morgan Stanley, Goldman Sachs, Merrill Lynch, Deutsche Bank and Barclays then.

These are instances of what economists call ‘winner’s curse’. RCB, just like RBS, was the winner of the bid but was “cursed” because the intrinsic value of the asset (read, Mills) bought was far less than its estimated value. Winner’s curse is a phenomenon that occurs in common value auctions, where bidders have no way of knowing the intrinsic value but bid based on their own assessment of that object. The winner is the bidder with the most optimistic estimation (evaluation) of the asset. However, the results of the auction show that the estimates of the product’s value of other bidders are usually much lower than that of the winner, giving him the impression that he bid too much.

In fact, the theory of the winner’s curse, which reflects the quirks of auctions or the bidding process, does not conform to the hypothesis of market efficiency. If the markets were efficient, the actual price paid by the highest bidder for an asset should be equal to its intrinsic value. Richard Thaler, the 2017 Nobel Prize winner in Economics and the proponent of the Nudge Theory wrote in Misbehaving: The Making of Behavioural Economics, “When many bidders compete for the same object, the winner of the auction is often the bidder who most overvalues the object being sold.

The phrase ‘winner’s curse’ was first put forward by three petroleum engineers of Atlantic Richfield, Capen, Clapp and Campbell, in their seminal work Competitive Bidding in High-Risk Situations and was published in the Journal of Petroleum Technology in 1971. They claimed that oil companies suffered low returns year after year in early Outer Continental Shelf oil lease auctions. In common value auctions, the value of the asset or item is essentially the same to all bidders, but the estimation of that value varies from one bidder to another. For example, it is difficult to estimate the potential value of an offshore oil field. So, if an oil field had an intrinsic value of $100 million, oil companies might guess its value to be anywhere between $50 million to $20 million. That said, winner's curse may not apply to winners in all auctions. Many products or services will have a private value and a common value. The paintings of Pablo Picasso or that of V S Gaitonde are bought for millions of dollars or rupees by collectors. The paintings will have a common value for all, but the private value may vary from one bidder to another -- information about which is not available to all bidders. Winner's curse may not arise in such cases.

The Nobel Prize in Economics this year has been awarded jointly to Paul Milgrom and Robert Wilson of Stanford University for, to quote the Nobel Prize committee, “improvements to auction theory and inventions of new auction formats." Wilson developed the theory for auctions of products, which have a common value – a value that is uncertain before the auction but, in the end, is the same for everyone. Some of the examples of products or services which have a common value are the telecom spectrum auctions, i.e., the future value of radio frequencies, or of the amount of minerals or coal in a particular area. The uncertainty for the bidders is in estimating the value of the telecom market in a particular circle or the value of minerals or coal in the block they are bidding for. Wilson showed why rational bidders tend to place bids below their own best estimate of the common value, as they are worried about the winner’s curse – that is, about paying too much.

Milgrom formulated a more general theory of auctions that not only have common values but also have private values that vary from one bidder to another. He analysed the bidding strategies in a number of well-known auction formats, demonstrating that a format will give the seller higher expected revenue when bidders learn more about each other’s estimated values during bidding. Milgrom and Wilson started out with fundamental theory and later used their results in practical applications, which have spread globally. Auction theory is indeed very useful as a branch of Economics and as Peter Fredriksson, chair of the Prize Committee said, “Their discoveries are of great benefit to society”.

(The writer is a CFA and a former banker and currently teaches at Manipal Academy of Banking, Bengaluru)