THE WINNER'S CURSE

by Deb Weidenhamer

For those of us who work in the auction industry, it is a familiar and comfortable world. However, the auction industry is but a fairly tiny corner of the wider world of business. To business people from other industries, auctions are an odd way of doing business that has very unique rules and customs. The viewpoints of business people outside of our industry can give us new insights into our traditional ways of doing business.

One example of an interesting outside viewpoint is the idea of the "winner’s curse". The winner’s curse is a theory advocated by Paul Klemperer, an economics professor at Oxford University who is specializes in Auction Economics. The theory states that when an item is auctioned, a large percentage of bidders are initially interested in buying at the starting bid. As the bidding continues, there are fewer and fewer people interested in making the purchase. Bidders drop out when the level of bidding exceeds their perceived value of the item. The last bidder is the person with the highest valuation of the item. If a bidder has an inflated idea of the actual value of an item, they will be the last person bidding and pay too much. The theory says that every winning bidder is the person who knew the least about the value of an item and therefore always pays too much. Paying too much for an item purchased at auction is the winners curse and Paul Klemperer believes it is an all-pervasive aspect of auctions.

Paul Klemperer’s idea of the winner's curse takes an overly negative view of auctions, but it does correctly identify one key element of the auction process. That is the fact that auctions severely punish those who bid without being knowledgeable. In a fixed-price (retail) environment a lack of knowledge does not result in paying a higher price. But conversely, in a fixed-price environment, having a lot of knowledge does not result in paying a lower price. The ignorant and the expert pay the same price. But if auctions punish those who lack knowledge, they also handsomely reward those who do have knowledge.

For example, what if everyone has too low a perception of the value of an item? This means that all of the bidders will make the mistake of dropping out too early rather than too late. Where general perceptions of an item’s value are too low, knowledge of an item’s real worth can result in the purchase at a fraction of its real value. Purchasing an item for a small fraction of its real value results in what I call the "winner’s blessing".

Anyone who has spent time in the auction industry has seen many examples of winner’s blessing. These are auctioneers’ favorite stories. At one of our auctions we sold a large and rather unattractive ingot of metal. The bidding started at $2.50 and ended at $15.00. The winning bidder had once worked in the mining industry and, unlike the other bidders, knew he was bidding on an ingot of 80% pure silver. He sold his purchase several days later for 100 times what he paid for it. While this level of profit from individual knowledge is unusual, it is exceedingly common for auction bidders to resell their purchases for 10 times what they initially paid.

Two types of knowledge most assist auction bidders in achieving a winner’s blessing. They are knowledge of the item itself and knowledge about how to resell the item. Auction buyers are often compulsive readers and researchers about the items they purchase at auction. They specialize in a single type of item or a small number of specialties. They learn as much as then can about the items that they bid on so they same spot the high-value items that others might miss. Many times at auctions I have watched experts bid on two items which looked exactly alike to me but one item sells for many times what the other sold for.

The other type of highly valuable knowledge is where to sell an item that has been purchased. To prove you purchased an item at 1/10 of its real value, you have to be able to sell it for 10 times what you paid for it. This knowledge of who might buy an item and what they are willing to pay for it is a powerful bidding tool. I have stood next to bidders who were on the phone negotiating a sale of an item that they were silently bidding on. The knowledge of exactly what an item can be sold for gives them the confidence to bid without the risk of a winner’s curse.

Knowledge offers such a powerful advantage that auction buyers will often try to use other bidder’s knowledge to their advantage. One of our auction regulars has a reputation as an extremely shrewd bidder. Many times he has bid on "junk" and later sold it for huge profits. Other bidders began to bid against him, even if they didn’t know exactly what they were bidding on. Their knowledge of his knowledge made them more confident of an item’s value and gave them a bidding advantage. He solved this problem by occasionally bidding on items that looked like junk and were in fact, junk. He would drive the bids up to ridiculous levels and then drop out of bidding. This introduced an element of risk into bidding against him, which dramatically decreased the value of his knowledge to other bidders.

One final aspect of the winner’s curse should be mentioned. This is whether the perception that someone paid too high a price and is suffering from winner’s curse is always accurate. The important question is, does the winning bidder feel they received a fair value for their money? A bidder’s high perceived value of an item may not be due to ignorance. Maybe the bidder has a strong sentimental attachment to the item, which causes them to place a higher value on an item they are bidding on. Maybe they need an item to complete a collection, so its value as the final member of a collection far exceeds its value as an individual item. Maybe their spouse has an inflated idea of how much money can be saved at auctions so they make purchases at auction that they would not be allowed to make retail. I have met a number of auction bidders who regularly bid far too much for items when bidding against a hated competitor. They were paying not just for the value of the item but for the satisfaction of taking it away from their competitor.

I think most auctioneers' experience with auctions is that the range of prices for items forms a bell-shaped curve. A few items sell for far less than what they are worth, a few sell for far more than what they are worth, and most sell for pretty close to their real value. These means that at any given auction a few people will suffer from winner’s curse, a few from winner’s blessing and most will just be the winning bidder. If the winner’s curse was really all that prevalent at auctions, and most purchasers resulted in suffering from it, I cannot believe that auctions would continue to grow in popularity – making them an auctioneer’s blessing.