There are two main reasons the winner’s curse is a common and dangerous trap in negotiations.
1. Your gains depend on the other side’s acceptance
When coached, most people are able to understand why the optimal offer is a bid of zero in the Acquiring a Company exercise – yet most readers will make a positive offer. When we bid on something, our gains depend on acceptance by the other party. This acceptance is most likely to occur under conditions undesirable to the bidder and favorable to the seller. Across many types of negotiation, most people fail to make this connection. Groucho Marx demonstrated his grasp of the winner’s curse when he said that he didn’t want to belong to any club that would have him as a member.
2. The other side knows more than you do.
After falling victim to the winner’s curse, you’re likely to notice that the other party – who is almost always the seller – was much better informed than you were about the terms of the deal. When you’re bidding on a commodity you know little about, your uncertainty is heightened. When you’re presenting this bid to an informed opponent, your expected return from the transaction will decrease dramatically. The average person will accept your offer only when the actual thing bargained over is worth less than your estimate.
In research that earned him the Nobel Prize, George Akerlof, Koshland Professor of Economics at the University of California, Berkeley, showed that the selective acceptance of offers can lead not only to bad outcomes for buyers, but to market distortions. The used car market offers a graphic illustration of the consequences of wide-spread fear of the winner’s curse. As most of us understand, the average used car on the market is hardly “average” in quality. If it were, the owner would have hung on to it or perhaps sold it to a relative or a friend. The bigger the lemon, the more likely it is to enter the marketplace. Intuiting this fact, most people approach used cars with caution: they bid low and get ready to walk away. In this fashion, the average quality and price of a used car becomes distorted, as does the used car market as a whole.
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