The Economics Book

294

AUCTION

WINNERS PAY

OVER THE ODDS

THE WINNER’S CURSE

A

uctions have been

around for a long time,

but economists have only

recently come to realize that they

are an ideal proving ground for the

competitive strategies of game

theory. Game theory came to

prominence in the 1950s when

mathematicians saw that simple

games could illuminate situations

in which people compete directly.

This idea proved hard to apply to

the real world. However, the strict

rules of an auction, with limited

participants and pokerlike buying

strategies, seemed much closer to

the theory.

Types of auction

The first person to apply game

theory to auctions was Canadian

economist William Vickrey in the

1960s. He compared the three most

common types of auctions. An

“English auction” is the method

used in British art houses, where

bidding goes up until only one

bidder is left. In a “Dutch auction,”

used in Dutch flower markets for

example, the price drops until it

reaches a price someone will pay.

In a “first-price auction” bidders

submit sealed bids, and the highest

bidder wins. Vickrey proposed a

IN CONTEXT

FOCUS

Decision making

KEY THINKERS

William Vickrey (1914 –96)

Paul Milgrom (1948– )

Roger Myerson (1951– )

BEFORE

1951 US mathematician

John Nash develops a concept

of equilibrium in games,

which becomes a tenet of

auction theory.

1961 Canadian economist

William Vickrey uses game

theory to analyze auctions.

AFTER

1971 It is shown that oil

companies bidding for drilling

leases may not be aware of the

“winner’s curse.”

1982 US economists Paul

Milgrom and Robert J. Weber

show that when bidders know

their competitors’ valuations,

an “English auction” gives the

best price for the seller.

Auction winners pay

over the odds.

In an auction where the value

of the sale item is uncertain,

every bidder makes his own

decision on its value.

If they decide their

valuations privately,

there will be a range of

different valuations.

The true value of the item

will tend to be around the

midrange of the different

bidders’ valuations.

The sale will go to the

bidder who overestimates

its value the most.