Session C

The Winner’s Curse

In Sessions A and B, each buyer’s valuation is independent in the sense that a bidder would not change his valuation just because he found out the value another bidder placed on the item for sale. In session C students consider situations where each buyer receives a private estimate of an item’s value. Each buyer’s estimate is correlated with the true value, so learning a competitor’s estimate would change a buyer’s beliefs about the item’s value.

Suppose for example that major oil companies are bidding for the right to extract oil from an off-shore tract. Each firm does its own seismic testing and forms an estimate of the tract’s worth. In this case, knowing that Exxon has a low estimate would lower the estimates of the other bidders. Let (z1,z2,…,zn) be the estimates of the n bidders. Then the value of the item is the average of these estimates is v = (z1+z2+…+zn))/n.

With full information about all the estimates, each bidder would have the same valuation. However each bidder’s estimate is private, a firm makes its bid for the oil-field bid based on its own estimate. The more optimistic the estimate, the more a buyer will bid, so it is the most optimistic bidder who wins the auction. Thus the winning bidder will be cursed by over optimism unless he carefully takes into account the fact that all other estimate are lower.