520 PART • 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 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