I took a class on game theory in business school but I found it difficult to apply what I had learned in a systematic and simple manner. In this post, Presh Talwalkar, does a fantastic job of presenting examples of game theory in action. In addition, Presh talks at great length about the concept of winners curse and the application of game theory to auctions.
Article Introduction (Via Mind Your Decisions)
Sometimes winning comes at too high a cost. In such cases, it is the winners that are the real losers. The phenomenon is known as the “winner’s curse” and it affects a wide variety of situations, from baseball free agency signings to stock market IPOs. Whether you are an executive in a big auction or a participant on eBay, it’s important to understand the winner’s curse. Here are a few thoughts on how and why the winner’s curse happens.
Article Excerpts (Via Mind Your Decisions)
“The winner’s curse in auction theory traditionally refers to the selection bias that arises because a bidder tends to win more often when his value estimate is too high than when it is too low.”
“The winner’s curse happens because players overbid based on their value. One way they could avoid this is by bid shaving, the practice of bidding a lower amount to account for risk of overpaying.”
Key points (Via Mind Your Decisions)
1. The winner’s curse affects auctions of common value
2. Examples include baseball free agency and oil fields valuation
3. The key problem is the winner will have the highest valuation and overbid. The fact others don’t want to pay is a bad sign, a form of adverse selection
4. Auction design and bid shaving are two ways to deal with the winner’s curse