Back in the 1980s, a young economist — and future Nobel winner — named Richard Thaler began writing a series of columns that challenged the dominant doctrine of his field.
At the time, most of the economics profession was smitten with a cartoonish picture of human behavior. A depiction of humans as selfish, smart, calculating, and self-controlled creatures who optimally choose what's best for themselves. It had become a bedrock of the mathematical models economists used to describe — and sometimes glorify — the free market.
Thaler rejected this model of human behavior. He pioneered the field of behavioral economics, which has sought to enrich our understanding of markets and the world by incorporating insights from psychology and other fields about how human beings actually behave. And this series of columns, published in an academic journal named the Journal of Economic Perspectives, was a sort of opening salvo for this revolution.
In column after column, Thaler shined a spotlight on anomalies that didn't fit with the tidy, mathematical portrayal of humans in popular economic models ("Anomalies" was actually the title of the column.)
One anomaly Thaler highlighted was what he called "The Winner's Curse." The winner's curse refers to the winners of auctions. That includes the classic auction with auctioneers speaking really fast, selling antiques or paintings or whatever. But it also applies to markets where people competitively bid against each other to buy something, which includes things like bidding wars over buying a house, companies competing to acquire other companies, and sports teams fighting to sign star rookies in a draft.
In the standard economic way of seeing auctions, the winner is someone who values it the most after a careful cost-benefit analysis of what they're bidding on, using the best available information. Presumably, the winner is, well, the winner. But what if the winner is, more often than not, actually the loser? What if winners, systematically, are the ones who pay too much for what they're buying?
In one of his columns, Thaler suggested exactly that. That, actually, in competitive auctions, the winner is often the one who makes a mistake and overpays. That is, the winner is someone who — perhaps irrationally — buys something for more than its worth. Hence the curse.
Some years back, Thaler compiled these old "Anomalies" columns in a book with a title inspired by this phenomenon. It's titled The Winner's Curse. Now, Thaler, together with his University of Chicago Booth School of Business colleague Alex Imas, just published a new edition of the book. It has new material that seeks to expand upon and update Thaler's groundbreaking columns. And, at the end of each chapter, the book describes how the evidence on each phenomenon has evolved and strengthened in the years since the original columns. With a replication crisis plaguing social science, this was nice to see.
The Origin Story Of The Winner's Curse
In an upcoming episode of The Indicator, Thaler tells the origin story of the winner's curse. " This is a phenomenon that was not discovered by economists or psychologists," Thaler says. Instead, he says, it was discovered by oil companies. Basically, oil drillers got into bidding wars over the right to drill plots of land. " And what they found was that the plots that they won had less oil than they expected." That is, the winners were the ones who tended to bid too much for drilling rights.
"And what they realized is there wasn't any problem with their geologists," Thaler says. "The problem was with their bidding."
It kinda makes sense why winners in auctions would actually often really be the losers (in the sense they pay more for something than it's really worth). Because when you think about it, the winner of an auction is the outlier. They're the ones who offered to pay the most. Everyone else's bid is lower, suggesting they believe — often quite correctly — a plot of land, or whatever they're bidding on, is not actually worth what the winner is willing to pay for it.
Researchers have found a winner's curse in many other domains. Social scientists have found it in lab experiments. Scholars have seen it in the market for book publishing, where auctioned books tend not to earn back their advances. The economists James Cassing and Richard Douglas found it in the market for free agents in Major League Baseball.
The financial economist Richard Roll found it when companies acquire other companies. He found that companies tend to overpay for the companies they acquire, and he wrote this could be the result of what he called the "hubris hypothesis." That is, titans of business are often too sure of themselves and too gung ho to buy other companies, and they misread the true value of what they seek to acquire and therefore overpay for them.
Thaler himself, together with Cade Massey, found a winner's curse in the top picks of the NFL draft. "Does the performance of the players selected with those early picks live up to the hopes and dreams of the teams that now have them? Not so much," Thaler and Imas write. "The owners may be dreaming of getting a Tom Brady with that first pick, but somehow they manage to forget that Brady himself was taken with the 199th pick!"
So how can you avoid the winner's curse? Thaler has some simple advice. Thaler told us: "The way you have to think about bidding in an auction is: if I win the auction, will I be happy?"
Thaler says you should be especially wary when you're in auctions or bidding wars with lots of people. If you're the winner in an auction with a lot of people, it suggests that lots of other people thought what you won is worth less than what you paid for it.
"The wider lesson for business is the more bidders there are, the more cautiously you need to bid," Thaler says.
Check out Thaler's new, revised book, The Winner's Curse. It's become part of the canon of behavioral economics. And listen to our upcoming episode of The Indicator with him.
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