Winners Curse - Business negotiation PDF

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WINNER’S CURSE INTERNATIONAL BUSINESS NEGOTIATION

NAME: SUMAN MONDAL ROLL NO: 27A EPGDIB 20-21 (HYBRID)

INTRODUCTION:

In common value auctions, the true value of the item for purchase is the same to all bidders. However, the parties who are competing to purchase the item are unaware of the true value at the time of bidding. Since the bidder with the highest estimated value (and, therefore, the highest bid price) wins the auction, the bidder with the highest overestimate of the true value is generally the winner. This is what leads to the winner's curse, as the winner potentially earns very low to negative returns from winning the bid. Therefore, the winner's curse is a tendency for the winning bid in an auction to exceed the intrinsic value or true worth of an item. The gap in auctioned versus intrinsic value can typically be attributed to incomplete information, emotions, or a variety of other subjective factors that may influence bidders. In general, subjective factors usually create a value gap because the bidder faces a difficult time determining and rationalizing an item's true intrinsic value. As a result, the largest overestimation of an item's value ends up winning the auction. The term winner's curse was coined by three Atlantic Richfield engineers (Capen, Clapp & Campbell in their 1971 paper “Competitive Bidding in High Risk Situations”) , who observed the poor investment returns of companies bidding for offshore oil drilling rights in the Gulf of Mexico. In the investing world, the term often applies to initial public offerings (IPOs). Comprehensively, the winner's curse theory can be applied to any purchase done through auction.

WINNER’S CURSE: The winner's curse, at its core, is a combination of cognitive and emotional friction and is usually recognized after the fact. The buyer is victorious in owning whatever asset they are bidding on. However, the asset is likely worth far less in resale value after ownership due to different factors affecting the purchase and influencing its value in the future. Overall, when an individual has to bid more than somebody else to get something, there is a good chance they end up paying more than they had wished. Unfortunately, it's often only after the transaction has taken place that they see this. Before the auction begins, nobody knows the item’s market value. Instead, every participant independently estimates the value before the bidding starts. Once the auction finished, the winner of the auction will be the person who bid the highest price. If we assume that the average bid price is close to the actual value of the price (the vertical red line in the below illustration), then winner will have paid more than this actual value (i.e., the black arrow). Winning the auction is thus bad news for the winner, because it suggests that the average value that the other bidders assign to the item is lower than what the winner paid. The more bidders, the more likely it is that some participants overestimate the value of the object and higher the eventual price paid by the winner. One way of avoiding the winner’s curse is by bidding below the value one thinks the item is worth (i.e., participant’s own estimate). By downward adjusting the bid will probably be closer to the average value and thus avoid paying so much.

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A. EXAMPLE OF THE WINNER’S CURSE IN INITIAL PUBLIC OFFERINGS (IPO):

When a company first goes public, investors must decide whether or not they want to buy shares at the listed initial price. Since investors intend to resell shares after a holding period, it is important for them to know how other investors value them and how much they can eventually resell them for. Different investors with varying amounts of information about a company will arrive at different future values for a share of its stock. Immediately after shares of a company begin trading publicly, investors who believe that the true value of a share is higher than its current price will buy some. Increasingly optimistic investors – who believe that the share’s true value exceeds the market’s price – will continue buying shares, which continues to increase its price. Eventually, the share reaches a certain price, specifically, the price that the most optimistic bidder is willing to pay, and stops climbing higher. This typically happens within the first few days of trading. This scenario can be viewed as a type of auction in which bidders intend to resell the item and do not know its common value. If we take the average of every investor’s value to be an estimate of the common value, then the individual values are distributed around it in some way. The investors who “won” the auction, meaning they got the share of stock in the end, are the ones whose estimates were above the common value as we defined it. If the share price eventually settles back down to the common value or below, then the “winning” investor will lose money, demonstrating a prime example of the winner’s curse. One recent example is the Snap Inc IPO that took place earlier this year. Shares were offered for around $17 each initially, but within a day of trading, the most optimistic investors had pushed the price up to $25. They won the auction by being able to obtain shares of the company, but in fact, they lost significantly when shares dropped steeply in price to around $15, where it remains today.

B. EXAMPLE OF THE WINNER’S CURSE IN AUCTIONING OIL FIELDS TO PRIVATE OIL COMPANIES:

The classic example of common value is represented by oil fields which are auctioned to private oil companies. One of the famous cases is that of the Chinese oil company Natural Petroleum Corporation which had to pay an exorbitant price at the auction of oil drilling rights held by Venezuela in 1997. The value which the various bidding oil companies attribute to a new oil field is essentially dependent on the supposed capacity of the oil resources. But nobody can say in advance how large this oil volume really is. Although the methods are improved continually, oil companies are still dependent on a few trial drillings for predictions even in times of geologic ultrasound analyses. The risk of faulty estimates always remains. The oil field can actually be larger than predicted, but also smaller. Trial drillings entail the danger that the drilling might be in the richest part of the oil field and consequently provide false assumptions about the surrounding area. As a result, the valuation of an auction item is characterized by a large degree of uncertainty; In addition, the capacity of an oil field represents information that all bidders need for their calculations. If the oil field is larger or smaller, then it affects each bidder in the same way. All bidders have the same plans for the oil field: To extract the oil and sell it. Consequently, the real value of the oil field is the same for all bidders. The real value of the bidder (the auction item for the bidder) is that value which the bidder would actually consider his indifference price with the hypothetical receipt of all imaginable information. He often only knows how to estimate the real value of an auction item years later, for example, when he knows the further development of the market in question. The indifference price is always only the best estimate which a bidder can assume to be the real value with all the information available to him. WINNER’S CURSE | 3

In Venezuela, all bidders had the chance to make a trial drilling. We can assume that the average value of the drillings of all bidders produces a better approximation of the real value than the individual drillings. But if the real value was close to the average value, this means that the one with the highest yielding drilling and the highest estimate certainly overestimates the oil field capacity. Although all bidders were to estimate the same real value, they calculated different indifference prices. In this example, the auction took place using a first-price-sealed-bid held by Venezuela. The following effect was produced: The one who submitted the highest bid was the one who had gotten the highest yield from the trial drilling and, consequently, had miscalculated most to their own disadvantage. At the moment when the winner of the auction was announced, the winner had to have understood that the other bidders must have had poorer yielding drillings. In this case, the oil field produced a lower yield than it was estimated.

__________________________________________________________________________________________________ REFERENCES: Berz, G., 2016. Game Theory Bargaining and Auction Strategies: Practical Examples from Internet Auctions to Investment Banking. Springer. Thaler, R.H., 1988. Anomalies: The winner's curse. Journal of economic perspectives, 2(1), pp.191-202. Bulow, J. and Klemperer, P., 2002. Prices and the Winner's Curse. RAND journal of Economics, pp.1-21. Kagel, J.H. and Levin, D., 2009. Common value auctions and the winner's curse. Princeton University Press.

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