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The $20 Auction and the Winner's Curse

A new subscriber dsecribed a rather unusual auction at the Harvard Business School. A $20 bill was auctioned, with the winner getting it, but the runner up would forfeit the bid. In essence, the seller got to collect from TWO people.

Certainly the bill was worth no more than $20. More to the point, the seller would more than recoup if there were two bids of say, $11 and $10,. Because the runner up would forfeit the bid, it might not be rational to bid more than half of $20, or $10, for the bill. Depending on the level of risk aversion, the bill could go for even less.

But when bidders passed the $20 mark, they were no longer bidding to win, they were trying to recoup their losses. In fact, the bidding got as high as $204, meaning that the "winner" lost $184, and the loser, presumably $203.

Takeover bids are much like this. The winner gets reputation points for winning, the loser "loses face." Hence, in a bidding war,  buyers are willing to pay above the economic value of the target for the other, "social" benefits. This is called the "winner's curse."