Auctions and Winner's Curse

Winner's Curse refers to the problem wherein the winner of auctions often overpays for his successful bid. Winner's Curse arises in auctions where there is uncertainty in the value of the item being auctioned. In its absence, the bidders are unsure about a successful bid value. If the value of the commodity is known or if there are many identical items being auctioned off, there is less likelihood of winner's curse.

There is this famous example from the Journal of Petroleum Technology (1971) explaining the Winner's Curse:
"Suppose several petroleum firms are bidding on the drilling rights to a piece of tundra. No firm is sure how much oil is underneath the property, so they hire a team of engineers to poke at the surface rocks and make a guess. The guesses will likely range from too low to too high. Some firm's engineer will probably guess right, but that firm won't win the auction. The winner will be the firm whose engineer was the most overoptimistic. The winning firm won't ultimately get as much oil as their engineers promised, meaning the firm paid too much. In short, the auction "winner" is ultimately a loser."

Auctions are an interesting case of departure from standard economic theory. Auctions with a large number of participants are more likely to cause inefficient outcomes, because the competing bidders invariably bid large and end up with a bad deal. Internet auctions, with the possibility of large number of participants, are especially vulnerable to the winner's curse problem. In fact, larger the number of participants, larger the potential for winner's curse. Alternatively, if an auction has to strike the right bid price for the winner, either there must be limited number of participants or the particular bidding process should keep off most potential bidders. But both these conditions go aginst the standard economic principles of competition.

There is also the rational bidder assumption. If any bidder turns out to be irrational, it has the potential to drive up a chain of irrationality, thereby severely distorting the price. Therefore, while theoretically auctions are the most ideal way of bringing buyers and sellers together, there are many pitfalls associated with them.

In the Vijayawada Municipal Corporation (VMC), we recently conducted a series of auctions to lease out our many vacant shopping complexes. The previous practice was to call for tenders and invite sealed bids on the goodwill amount. Since this process was not generating adequate response, it was decided to go in for auctions. These auctions were initially only single-bid, ascending (English) price auctions. But later, some of the auctions were held as single bid descending (Dutch) price auctions. There were also a few second-bid auctions, where the highest bidder gets the shop, while paying the second highest bid as goodwill amount.

It was observed that when the competition is intense, the ascending price auctions fetches better prices for the VMC. The single-bid auction appears to be the better option when the competition is neither stiff nor weak. But when the competition is limited to two or three bidders, as is the case many times, it is more beneficial for the auctioneer to hold Dutch auctions. In such Dutch auctions, the reserve price can be kept at two times the minimum goodwill amount, and the first bidder wins the bid. It is observed that in case of limited competition, ascending auction bids rarely go much beyond the reserve price. Whereas in Dutch auctions, by marking up the reserve price and thereby changing the bidding framework, we incentivize (or anchor) the bidder to quote more.