On the Winner’s Curse
Suppose you got what you wanted. Great—right? Uh…not if you overpayed. This is “the winner’s curse,” on which John Kay, as usual, doesn’t fail to entertain:
Imagine someone wheeling a trolley of attractively packaged objects down Wall Street and through the City of London. The trolley has three shelves. On top are executive toys designed by rocket scientists. You do not quite know how they work but they are said to relieve stress. Below is the lucky dip. These items have been packaged and repackaged so many times that no one is quite sure what is in them any more, but they are carefully graded A, B and C and priced accordingly. In the bargain basement, banks and other wholesalers offer stock items at what looks like a good price.
All packages are attractively if opaquely wrapped, the sales staff persuasive. Since unsold objects remain intact, they can be kept by the original owner or offered tomorrow in different packaging, which can be customised to fashion and individual taste. Only a few items a day need leave the trolley to establish a profitable business, so you need sell only to those willing to pay too much.
It is hard to make out, far less understand, the labels on the shelves, but they seem to read something like “exotic derivatives”, “collateralised debt obligations” and “credit risk insurance”. To understand why these complex instruments have multiplied, and why that multiplication is dangerous, it is helpful to understand the distinction between private value and common value….
Businesses that participate in auctions, and agencies that design them, have learned about the winner’s curse and adjust their behaviour in the hope of avoiding it. But there is no escaping the underlying problem: an object of uncertain value is more likely to be owned by people who overestimate that value than by people who underestimate it. European mobile phone companies paid too much for their auctioned 3G licences because telecommunications companies are run, and their shares owned, by people excessively optimistic about the future of mobile telephony. Businesses are always managed, and shares are always owned, by people who think these businesses have good prospects.