Adapted from “How to Win an Auction—and Avoid the Sinking Feeling that You Overbid,” first published in the Negotiation newsletter.
Imagine that at the beginning of class, a professor produces a jar full of coins and announces that he is auctioning it off. Students can write down a bid, he explains, and the highest bidder will win the contents of the jar in exchange for his or her bid.
After everyone has written down their bids, the professor polls the class to find out how they bid. Bob turns out to be the high bidder, at $45.
“Congratulations, Bob, you’ve just won all the coins in the jar!” the professor says. “How do you feel?”
“Lousy,” says Bob, before even hearing how much money the jar contains.
Professor Max Bazerman of Harvard Business School has held this auction many times in his classes, and it tends to play out the same way each time. The winning bidder feels embarrassed and disappointed before finding out how much money is in the jar. Why? Absent a special talent for counting coins, Bob has just been identified as the most optimistic person in the room. When everyone in an auction is trying to assess the same thing, the winning bidder is likely to have overpaid. And indeed, in this auction, the jar contained only about $20 in coins.
This simple game is a classic illustration of the winner’s curse phenomenon in competitive bidding. The winner’s curse describes a common problem in negotiation: lacking an advance understanding of this phenomenon, the party who wins an auction of a commodity of uncertain value with a fair number of bidders typically pays more than the asset is actually worth.
One way to reduce your odds of becoming the next victim of the winner’s curse is to evaluate—before you enter an auction—whether a private-value asset or a common-value asset is at stake. A private-value asset offers unique value to different bidders. One bidder for a first edition of a novel may plan to resell it to a book dealer, for example, while another wants it because she is the author’s great-granddaughter. By contrast, common-value assets, such as an oil lease or a jar of coins, should have equal value to all bidders. Bidders may not know how profitable the asset will be, but it would provide equal value to all of them.
If you are bidding for a purely private-value asset, you need not fear the winner’s curse. You should feel fine about winning an auction for your great-grandfather’s book, as its sentimental value is yours alone.
Complicating matters, however, is the fact that most assets have both common-value and private-value elements. That book might be priceless to you, but someday your family may want or even need to resell it—thereby introducing a common-value element. Similarly, a new manuscript being auctioned to publishers may be primarily a common-value commodity, as each publisher has the goal of selling as many copies as possible.
But if one publishing company has special marketing and distribution skills in that particular genre, the publisher may be correct in valuing the book more than her competitors do.
In short, bear in mind that the risk of the winner’s curse will be greatest when you’re bidding for assets with a strong common-value element.