(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 545

520 PART 3 • Market Structure and Competitive Strategy

• winner’s curse Situation in
which the winner of a commonvalue auction is worse off as a
consequence of overestimating
the value of the item and
thereby overbidding.

690 and that you win the auction with a bid of $6.80. Should you be happy
about winning? No—you will have paid $6.80 for $6.20 worth of pennies. You
will have fallen prey to the winner’s curse: The winner of a common-value
auction is often worse off than those who did not win because the winner was
overly optimistic and, as a consequence, bid more for the item than it was
actually worth.
The winner’s curse can arise in any common-value auction, and bidders
often fail to take it into account. Suppose, for example, that your house needs to
be painted. You ask five companies to give you cost estimates for the job, telling
each that you will accept the lowest estimate. Who will win the job? It will probably be the painter who has most seriously underestimated the amount of work
involved. At first, that painter might be happy to have won the job, only later to
realize that much more work is required than was anticipated. The same problem can arise for oil companies bidding for offshore oil reserves when the size of
the reserve and cost of extraction are uncertain (so that the value of the reserve is
uncertain). Unless the companies take the winner’s curse into account, the winning bidder is likely to win by overestimating the value of the reserve and will
thus pay more than the reserve is worth.
How should you take the winner’s curse into account when bidding for an
item in a common-value auction? You must not only estimate the value of the
item that you are bidding for, but also account for the fact that your estimate—
and the estimates of the other bidders—are subject to error. To avoid the winner’s curse, you must reduce your maximum bid below your value estimate by
an amount equal to the expected error of the winning bidder. The more precise
your estimate, the less you need to reduce your bid. If you can’t assess the precision of your estimate directly, you can estimate the variation in the estimates
of the other bidders. If there is a lot of disagreement among these bidders, it is
likely that your estimate will be similarly imprecise. To measure the variation in

bids, you can use the standard deviation of the estimates, which can be calculated using statistical methods.
Oil companies have been bidding for oil reserves for years, and thus are able
to estimate this standard deviation quite well. They can thereby take the winner’s curse into account by reducing their maximum bids below their value
estimates by an amount equal to the expected error of the winning bidder. As
a result, oil companies rarely feel they have made a mistake after winning an
auction. House painters, on the other hand, are often less sophisticated in their
bidding decisions and suffer from the winner’s curse.
The winner’s curse is more likely to be a problem in a sealed-bid auction
than in a traditional English auction. In a traditional auction, if you are the only
bidder who is overly optimistic, you can still win the bidding by offering only
slightly more than the second-highest bidder. Therefore, for the winner’s curse
to be a problem, at least two bidders must be overly optimistic. By contrast, in a
sealed-bid auction, your optimism could encourage you to outbid everyone else
by a substantial margin.

Maximizing Auction Revenue
Now let’s return to the question of auction design from the viewpoint of the
seller. Here are some useful tips for choosing the best auction format.
1. In a private-value auction, you should encourage as many bidders as possible: Additional bidders increase the expected bid of the winner and the
expected valuation of the second-highest bidder as well.