In auctions and other competitive bidding situations, the winning bidder is typically thrilled to get the prize—at least, at first. But as time goes on, the prizewinner may learn that, due to a phenomenon called the winner’s curse, they overpaid for the commodity.
Why would the winner of an auction or other competition be “cursed”? When an item of uncertain value is up for grabs, the average bid tends to be closest to the item’s actual value, since it distills many bidders’ estimates. By contrast, the winning bid tends to be the boldest and most extreme bid—and thus a less accurate assessment. The winner ends up feeling cursed upon realizing they overpaid.
A case study from the insurance market illustrates the winner’s curse in action and offers clues on how to avoid it.
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The Winner’s Curse in Action
The cost of homeowners insurance has skyrocketed in recent years in the United States and elsewhere, due in large part to the rise in climate-related disasters and inflated construction costs. In California, where consumer-protection laws prohibit insurers from raising their rates rapidly, many insurers say they are paying more in claims than they receive in premiums.
In a National Bureau of Economic Research working paper, economists Judson Boomhower, Meredith Fowlie, Jacob Gellman, and Andrew J. Plantinga explored the competition among insurers for California customers and found evidence of the winner’s curse.
“We were really struck by the variation in how firms are pricing risk,” Fowlie told Berkeley News. Some companies were able to price insurance at a very granular level because they had access to abundant information about wildfire risk and other relevant data. By comparison, companies with less access to such information were pricing insurance at a coarser level—for example, by zip code.
Such companies may worry that their only potential customers are owners of higher-risk homes that the more informed companies decline to insure. Fearful of becoming victims of the winner’s curse, these insurers inflate their rates, explains Fowlie. They might also refuse to insure higher-risk homes.
In California, limits on insurers’ rate hikes can be contested only through a slow and costly public-hearing process. State lawmakers have been considering reforms to make the process more favorable to insurers. But to ensure that insurance remains available and affordable, all insurers will need greater access to “more granular, more sophisticated wildfire risk estimates,” according to Fowlie.
Fear of the Winner’s Curse
This winner’s curse example highlights that in many auctions and sales competitions, some bidders have better access to the information needed to assess an item’s value than other bidders do. At an estate sale, for example, an experienced art dealer will be better positioned to make an informed bid on a painting than a neighbor who simply thinks the painting will look nice above their couch.
When a bidder is aware that they are less informed than other potential bidders about an item (whether an insurance contract or a painting), they may overcompensate with a more competitive bid to try to avoid the winner’s curse. This could lead them to forego the item unnecessarily with a losing bid. In the California homeowners insurance case study, it could lead insurers to overcharge owners of homes that aren’t actually that risky or to “exit high-risk market segments to limit their exposure,” Boomhower and colleagues note in their paper.
“Policies that improve market-wide understanding of wildfire risk could improve affordability without sacrificing availability,” the researchers write.
Kicking the Winner’s Curse
The following remedies can help parties avoid the winner’s curse:
- Acknowledge what you don’t know. Many people plunge into auctions full of enthusiasm. Instead, pause before bidding to consider whether you might be at an information or expertise disadvantage relative to your competition. What might they know about the item that you don’t?
- Arm yourself with information. If you recognize that other bidders are likely more informed than you are, try to better educate yourself about the commodity at stake. This might mean doing your own research or hiring an expert to offer a valuation. Doing so can help you decide whether it’s wise to submit a bid or not. Often, a previously attractive item in an auction loses its luster once we know more about it—and the smartest thing to do is to walk away.
- Level the playing field. When some auction bidders are likely to be much more informed than others, there may be steps that the auction holder or other interested parties (such as government regulators or lawmakers) can and should take to reduce this asymmetry for the betterment of the market, such as giving all bidders access to information that would help them submit more accurate bids. Doing so could lead to a fairer and more efficient competition.]
Have you ever been the victim of the winner’s curse?
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