Winner’s curse
Julio De Castro
The notion of a winner’s curse has been developed for the examination of situations that occur in the context of auctions, particularly auctions in which bidders have common values. However, the concept can be applied to entrepreneurial behavior and can be a great hazard in the decision making process of over eager entrepreneurs. First, the concept and history of winner’s curse is examined. Second, applications of the concept to the entrepreneurial context are explored. Third, examples of situations in which the winner’s curse has been operative are presented.
The Concept of Winner’s Curse
The concept of a winner’s curse was introduced to discussions in economics research by Richard Thaler (1988). He explained that in an auction with common values – that is, an auction where the item has the same intrinsic value to all bidders, yet no bidder knows the exact value – it was likely that the winning bidder would bid an amount exceeding that item’s intrinsic value. The main reason for this phenomenon is that the winning bid is likely to be based on the most optimistic estimate of the value of the item: ergo, the winner’s curse.
The winner’s curse phenomenon is particularly interesting regarding the assumptions about the rationality of individuals. If all individuals are rational, the winner’s curse should not occur. But acting rationally in auctions, especially common value auctions, requires distinguishing between the expected value of the object, based only on the prior information avail able, and the expected value if the auction is won.
Furthermore, the seriousness of the winner’s curse problem is affected by the number of bidders in an auction. When there are more bidders, a person has to bid more aggressively to win the auction. However, bidding more aggressively increases the probability of overbid ding for the item. Thus, the individual overestimates the value of the object. Evidence from field studies suggests that even though learning can help decrease the problem, ‘‘learning is neither easy nor fast’’ (Thaler, 1988: 194). Evidence of the prevalence of the winner’s curse is presented in both the finance and economics literatures (Kagel and Levin, 1986; Bazerman and Samuelson, 1983; Samuelson and Bazerman, 1985) and in real life. Examples of winner’s curse include the bidding for free agent baseball players (Cassing and Douglas, 1980) and the market for corporate takeovers (Roll, 1986), as well as numerous anecdotal cases, such as the bidding for book publishing rights and for tele vision interviews, and the auction of UMTS third generation phone licenses in Europe.
The Winner’s Curse and the Entrepreneur
The problems highlighted by the winner’s curse can be particularly troublesome for entrepreneurs. In situations in which the individual is eager to enter the business and/or the opportunity, the likelihood of a winner’s curse is high. Thus an entrepreneur that is highly interested in landing a particular opportunity could over bid for the business and the likelihood of earning a profit from a subsequent transaction is lessened.
Avoiding the winner’s curse is a crucial concern for the entrepreneur. Given the nature of the entrepreneurial process, it is likely that eagerness to land new business or a new client will drive many entrepreneurs to incur the winner’s curse. Furthermore, it is unlikely that a first time entrepreneur will have the slack resources necessary to carry the extra costs from an overpriced acquisition. Incurring the winner’s curse could lead to failure for new entrepreneurs. However, research shows that experience can be a moderating factor, in that more experienced bidders are less likely to incur the winner’s curse. A new entrepreneur might not have the experience necessary to avoid the trap.
Kagel and Levin (1986) found that the winner’s curse is more pronounced in larger groups. The worst scenario is the situation in which multiple new entrepreneurs bid for a new technology with uncertain payoffs. The results of the UMTS spectrum auctions in most West ern European countries represent such a situation, although in this case most bidders, except firms such as Vodaphone and Orange, were former state telecom monopolies. The new technology and uncertainty of the outcomes, coupled with a system that was designed to generate the most revenue for governments, resulted in a situation in which there was a low probability bidders could recoup their investment. Additionally, most firms are struggling to implement the structural changes necessary for the system, and with no dates for implementation in the near future.
Finally, the eagerness of new entrepreneurs to land new businesses and to make the opportunity successful compounds the problems of winner’s curse with the possibility of escalation of commitment. Escalation of commitment is the tendency to become entrenched in a failing course of action (Staw and Hoang, 1995; Staw, 1976). Entrepreneurs who have committed themselves to a particular course of action and have paid more for a product/service than its intrinsic value, might commit additional re sources without favorable results in order to justify the original commitment. Even though Zardkoohi (2004) has argued that organizations in a competitive environment escalate commitment toward successful strategies and against failed strategies, it is not clear that entrepreneurial organizations are likely to overcome the problems created by the winner’s curse.
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