Is the price determined at auction objective value, or an illusion created by momentary passion? This blog post examines the winner’s curse and the pitfalls of price determination.
It is said that John Lennon’s guitar sold at auction for over 10,000 times its purchase price. This guitar is not merely an instrument; it is an important legacy that graced a page in music history and holds symbolic value for fans, which is why it was assigned such a high value. The winner who experienced the joy of winning the auction paid a price commensurate with the joy they could derive from the item, and the seller was likely satisfied with the high price.
However, if the winning bidder soon grows tired of Lennon’s guitar, they will soon realize the item was overvalued. Due to the nature of auctions, where value is assigned based on emotion, prices are often set above their actual worth due to momentary passion and excitement. While today’s winning bid may seem efficient, in the long run, it may not be a rational price level at all. Ultimately, the price determined at auction reflects the value at that moment, but whether that value will endure over time remains uncertain.
Consider, for example, the auctioning of crude oil drilling rights. Suppose Company A employs scientific methods to calculate the value most accurately, given the inherent uncertainty in predicting oil reserves and commercial viability. Yet, this does not guarantee Company A will win the auction. Instead, Company B, which has made the most optimistic and overvalued prediction, secures the rights. In this scenario, the winner of the drilling rights becomes the loser in the market, suffering significant losses. This decision significantly impacts not only the commercial value of the resource but also the future of the company itself. This phenomenon is called the ‘winner’s curse’. It arises from having assessed the uncertain future value too boldly.
If buyers are rational, they bid a price suitable for their intended use. As a result, efficient exchange occurs at a fair price. In economics, “efficient exchange” means all parties trade at a price where no one incurs a loss. For example, if the cost including a reasonable profit is $10, selling it for $20 or $8 is inefficient because someone bears the loss. However, selling it precisely for $10 allows both parties to exchange while being satisfied, establishing an efficient transaction. No price other than $10 can satisfy both parties. This is why monopoly prices are inefficient and competitive prices are efficient.
Auctions are a process for determining efficient prices. If all participating buyers are rational, the winner’s curse does not occur. Especially when there is clear information about future value or when many similar goods are traded, a rational price is determined. This rationality plays a crucial role not only in auctions but also in financial markets. Therefore, efficient prices can also be formed through auctions in the stock market. However, if someone acts irrationally, auctions can yield unexpected results. Just as stock prices can have bubbles, auction prices can also rise excessively. Consequently, the winner must bear the pain and curse of irrational decision-making.
