The Winner’s Curse and Reverse Auctions

The winner’s curse is an interesting (certainly it sounds interesting) feature usually discussed in relation to forward auctions – i.e. selling auctions. Basically it says that the winner of an auction is the one who has over-estimated the value of the item being auctioned.

This is how it works. It’s a very theoretical example but the point is not to be accurate, it is to illustrate a point:

5 companies want to buy an oilfield. They all have roughly the same technology at their disposal for estimating the amount of oil in the oilfield. They can all generate roughly the same amount of income from the oil. Theoretically some companies will under-estimate the value of the oilfield, and some will over-estimate.

Let’s say the oilfield is worth 100 units. Let’s say, that the oil companies have estimated the oilfield’s worth at 80, 90, 100, 110 and 120 units respectively.

Let’s now say that these 5 companies have been invited to submit sealed bids for the oilfield. And let’s say that they all bid 10 units less than the price they think it’s worth to them (so that they can make some profit), then you would get bids of 70, 80, 90, 100 and 110.

I know that this is a very simplified example – and I’m not going to go into digressions about net present value and the rates of return et al.

The point is that, when you are selling something that is worth roughly the same to everyone who is buying it, and you sell via a sealed bid, then the person who wins it is the one who over-estimated its value. In this example the company who estimated the value at 120 bids 110 and finds that the oilfield is worth 100.

That is the winner’s curse. Similar logic goes for normal “english” auctions as well.

But what about reverse auctions?

In a reverse auction, bidders (suppliers) are bidding down their margin. You would hope that bidders understand their cost structures, so would be unlikely to bid below their cost due to having under-estimated their cost. Of course, there are other reasons why bidders might bid below cost if they have particular strategic reasons for trying to win a particular contract. They would do this with their eyes wide open, though, so you can’t really talk of a curse.

If this is true (and I haven’t seen any serious studies on the subject) then it would mean that reverse auctions are even more efficient at allocating resources optimally than forward auctions.

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