Avoid the Auction Winner’s Curse
Nobel Prize Winning Techniques to Minimize Regret
Your cellphone works thanks to the careers of two American economists — and they just won the Nobel Prize in Economics.
(More accurately: The 2020 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.)
Their work may not help you win more eBay auctions or to pay less money — but it can help you understand the psychology behind the most effective bidding techniques.
And it is helping to organize the world so it functions efficiently, saving us all money.
Paul Milgrom and Robert Wilson (both of Stanford University) are known for coming up with Auction Theory — how to put together auctions that make money for whoever is selling something.
We’re all familiar with standard auctions where we bid against each other for an item.
But there’re many auctions that are not as well known, but are even more important: spectrums of radio broadbands, fishing rights and emissions allowances for carbon dioxide.
These often involve the government, which wants to maximize revenue the same as any business — but also to attain social goals of encouraging competition and giving consumers choices.
Auction bidders want to win while paying the least amount possible. Yet the “Winner’s Curse” is common.
That’s where you realize you’ve paid more money than the rest of the world believes the item is worth. We all like bargains, but auction winners have often overpaid.
The Problem With Most Auctions
One key aspect is Milgrom’s theory is the concept of “private value.” That is what each individual bidder values the item at — which clearly can vary enormously from bidder to bidder. It’s partly based on the bidder’s perception of the item’s current market value. It’s also partly subjective because different people place less or more value on the item — for reasons unique to their specific situations.
The value you as one bidder put on the item is something only you know. How high will you bid to get it? You know, but the other bidders don’t — just as you don’t know how high they’re prepared to go.
Depending on the type of auction, you don’t want to lead off with your highest bid. Rational bidders will bid low, hoping they can win while also saving money.
Auctions also have a “common value.” In the end, that value will be the same, but it’s unknown during the actual auction.
That’s why auctions are “games,” with all parties having incomplete information.
In auctions for fishing rights, the value of those rights depends on the price of the fish. But the fishing operations bidding on those rights don’t know what that price will be, because it’s in the future.
Therefore, it’s possible to pay too much for the fishing rights. If the price of the fish will be $20,000, you don’t want to pay $25,000 for the right to catch those fish.
Also, you may pay “too much” for an item simply because you want it badly enough and you can afford it.
I just googled the market price for FANTASTIC FOUR #1, and it’s $135,000.
But what if Bill Gates decided to collect Marvel Comics? If his private value for the first FANTASTIC FOUR comic was $100 million, nobody else would stand a chance against him, unless it’s Jeff Bezos or Warren Buffett.
Overpaying is what’s known as the winner’s curse.
The winner overvalues the item relative to the rest of the market.
The same kinds of issues arise when contractors bid on a job. They want the business, but usually not badly enough to perform a job at a loss — unless it would lead to more profitable business deals.
When you make an offer to buy a house, that’s essentially an auction as well — especially in booming real estate markets, when many people vie for the same house.
Milgrom Came Up With the No Trade Theorem
We tend to automatically assume that when we trade one thing for another (say, baseball cards), if both parties agree, it’s an equal transaction.
But that’s not necessarily true. Maybe the baseball card somebody wants you to give them in trade for another is worth more than you realize. Trading a Mickey Mantle for a Gregg Jefferies is obviously not an equal transaction.
Milgrom is the World’s Foremost Auction Designer
Through his study of auctions and development of Auction Theory, Milgrom has helped governments and businesses design auctions so they’re structured in unconventional ways.
But his unique designs allow all participants to reach their goals.
When you’re buying through an auction, you want to get the most for the least. Most auction sellers want to obtain the highest possible price. But some have other goals. Governments may wish to allocate scarce resources in a way everybody agrees is fair, efficient and beneficial to the ultimate consumers.
Milgrom and Wilson’s Auction Theory has been used around the world to distribute such items as radio frequencies (governments can’t allow radio station broadcasts to overlap), electricity and emissions allowances for carbon dioxide.
Such things are clearly not as simple to sell by auction as more traditional items such as estates or eBay’s inventory.
Auctions Aren’t New
Economic historians have documented auctions in China, Babylon, the Roman Empire and other places going back as far as 2,500 years.
Of course, without modern technology, those auctions were simple, and took place in person.
Today’s society is much more complex.
Over time, sellers have come up with basic types of auctions. The English type, where buyers bid against each other, driving the price up until only one bidder remains, is the most well-known.
However, business and governments often give jobs of work based on contract bids. Each bidder submits a sealed bid without knowing what their competitors will bid, and the job goes to the highest bidder.
But many situations require more complex auction models with special rules.
How Milgrom and Wilson Enabled the Wireless World
Beginning in the early 90’s, technological advances caused a surge in demand for radio broadcast broadband signals across the spectrum.
Obviously, that included the beginnings of the cellphone era — though cellphones of that era were huge, heavy and unreliable.
The government controlled who had access to the radio frequencies. Basically, companies applied for them by telling the government how great they were. Sometimes the government distributed access to these frequencies through lotteries — so the winners were purely random.
The entire process was inefficient — and it did not ensure maximum revenue for the government (to save the taxpayers money) and it did not ensure the best coverage for consumers. The government wanted to make sure the companies that would value the access the most would win — and to avoid monopolies.
The process is also complicated because these broadband frequencies are related to distance. The government wanted to make sure all areas of the United States were effectively covered — but without overlap.
And there’re numerous technical complications involved.
Milgrom and Wilson designed the auctions the government used to allocate the resource of the broadband spectrum.
The Federal Communications Commission (5G) is still using their work to carry out 5G spectrum auctions.
Check out my Income Investing Secrets newsletter now — click here.
