Whenever somebody asks me about behavioural economics, a good way of preventing their eyes from glazing over is to start by telling them about running experiments with real people. And for a good reason, because it’s by far the most fun part of the work! So when we were asked to run some experiments for visitors of the University of Nottingham’s open day, my colleagues and I jumped at the chance. We ran two experiments: a common pool resource game – I will blog about that later – and a ‘buying a company’ game set up to bring the winner’s curse upon our unsuspecting participants.
The winner’s curse was first discovered during research on oil field auctions in the 1970s, which often lead to low rates of return for the oil company with the winning bid. The intuition behind this phenomenon starts with the assumption that the winning bidder is the one with the most optimistic prediction of the amount of oil in the oil field. If the average prediction of all oil companies in the auction is accurate (you may or may not believe this, it’s like Galton’s famous “guessing the weight of an ox” but then with lots of money at stake), then the most optimistic prediction must be an over-estimation of the actual amount of oil available. The winner of the auction thus makes a lot less money than predicted, and is thus ‘cursed’ by winning the auction.
The experiment we set up – which is based on Samuelson & Bazerman (1984) – has a nice and simple way of representing the uncertain value of the asset for sale. After a prospective buyer (a participant) submits an offer, we draw a ball from a bingo cage that might have any number between 0 and 100 on it (with equal probability). Next, the value of the asset (a fictitious company) is multiplied by 1.5 to give the value of the company to the prospective buyer. If the prospective buyer’s offer is higher than the number on the bingo ball, he will buy the company at his offered price. The profit or loss of a buyer is the difference between his offered price and the value of the company to him (to recap, this was 1.5 times the bingo ball number).
My friend and colleague Antonio entertains some prospective buyers of our fictitious company...
Sounds like good value? Here’s the catch: if the price at which you offer to buy the company is high enough to exceed the number of the bingo ball, the average value of the bingo ball number is halfway between zero and your offer. So if you offer a price of 60, the average value of the bingo ball for a winning bid is 30. Even though this number is multiplied by 1.5, you should still expect to make a loss! Most people make the mistake of disregarding the condition of winning (“if my offer is high enough”) and simply calculate the average bingo ball number in a random draw (this is 50) and base their bid on that. Our experiment on the open day showed exactly that – a lot of people submitted positive bids and most of them (2 out of 3, as a ‘fair’ bingo cage would predict) lost money. Amazingly, the only one to submit an offer consistent with Nash equilibrium (zero) was a 10 year old boy!
So you might say, “What does a simple experiment have to do with oil field auctions with big companies?” Well, think about what these experiments achieve: we are able to explain the outcome in the field (losing money) with a behavioural regularity (a failure to use conditional reasoning) that occurs in a particular environment (uncertain asset value, asset is worth more to buyer than seller). If economists can come up with a behavioural intervention that succeeds in ‘fixing’ behaviour in a laboratory experiment, then this intervention might be scaled up to work in the real world. (So far, laboratory experiments indicate that the winner’s curse in the ‘buying a company’ game is hard to get rid of completely.) Another way of thinking about this is that economists can use experiments to figure out which institutions (market rules) lead to the winner’s curse, and promote the use of alternative market structures (for example, more markets for information) such that people don’t bring themselves to financial ruin by making over-optimistic predictions.
Beyond Discovery has more information on winner’s curse research in economics.