#2 Behavioral Economics & Auctions
Concepts that may determine bidding behavior
Endowment Effect:
An emotional bias that causes individuals to value an owned object higher, often irrationally, than its market value
This is a recurring phenomenon for shoppers on eBay. Once you start bidding on scarce or unique items, you may develop a certain attachment towards the product. The more time you invest in the auction process, the more you value the product and think of it as your own. And beyond a certain point, this feeling of “entitlement” or “endowment” drives you to bid aggressively (sometimes at prices higher than the conventional listing prices) to win what you believe is rightfully yours. Perhaps, committing to a ceiling price beforehand and minimizing chances of reneging on that committment could help you to not fall prey to such biases.
Anchoring:
A behavioral bias in which the use of a psychological benchmark carries a disproportionately high weight in a market participant’s decision-making process
This primarily relates to the starting price or the first bid in auctions. Earlier studies hinted towards the hypothesis that initial asking price may create a strong reference point in your mind, no matter how much you do not agree with the valuation and do not want it to influence your bids. Hence, it is quite likely to expect that lower starting prices in auctions would lead to low final price. However, it may not be that simple and low starting points could actually lead to more favorable outcomes. For instance, bidders may believe that they actually have a chance at winning and this feeling could facilitate market entry and participation. This surge in number of bidders further provides signalling and social proof that an auction is worth participating in and can further bring in more bidders who try to do outdo each other to extract that “value”. To minimize the loss incurred on account of anchoring effects, it is recommended to question the rationale of arriving at the anchor prices. And as advised by behavioral economist Daniel Kahneman, walk out of any bidding process that has an outrageous anchor.
Winner’s Curse:
A phenomenon in which the bidder with the most optimistic valuation of product wins the auctions and ends up overpaying — thus feeling a sense of regret
The asset put up for auction can have a “private value” or a “common value” or both. Take the example of a 19th century Van Gogh painting of “Starry Nights” in your grandfather’s chamber. In the art markets, there would be a certain value for this painting (primarily dependent on how much it could resell for). This is a “common value” derived from what prospective buyers are willing to pay for it factoring commonly known characteristics of the auctioned object. However, consider the personal value you may associate with this painting — it may be symbolic of your memories of your grandfather and the value you associate with it is private to you and independent of the market. This is a “private value” that is primarily unknown to other buyers. So, imagine a bidder quotes a very high bid in this art auction. Other potential bidders would constantly be in a quagmire whether the inflated bid is a result of a “private value” (in which case they could bow out) or a “common value” (in which case it could indicate that they didn’t have adequate information on product quality to value it correctly and may encourage to stay longer & bid more).
Especially in common value environments (such as auctions for mining a particular patch of land), the winner may be the one with the largest positive error in valuing the product and may end up losing money. The extent to which bidders anticipate “the winner’s curse” influences the caution with which bids are placed. This is the reason independent assessments on the value of the underlying resources (such as the mining reserves) can help bidders to overcome the fear of the “winner’s curse” and bid rationally.
For example: in open English auctions (where the asking bid price is raised from low to high until the reserve price is met), bidders are aware of the competing bids and are constantly updating their valuation. So bidders recognize that risk of feeling that regret may be lower. However, in open Dutch auctions (where the asking bid price is reduced from high to low until the reserve price is met), it is possible that the bidder battles between the risk of overbidding and that of potentially losing out the item.
The impact of the “winner’s curse” has been seen in the differential value realized in second price, sealed bid auctions vs first price, sealed bid auctions. In any sealed bids, the bidders are almost blind to the competing valuations of the product. In first price, sealed bid auctions — the winner needs to pay the price he quoted (which may be much higher than the second price and that differential could have costed the opportunity to make profits from the deal). Hence, bidders are generally more conservative in quotes. However, in second price, sealed bid auctions — the winners are assured of paying the price of the second highest bid. This raises the confidence to quote high bids, thus realizing better values for the product auctioned.
Competitive Arousal
A phenomenon in which the motivation for bidder moves away from making the best decision to winning at any cost
According to the competitive arousal theory, intensifying the competitive situation can motivate bidders to overbid so as to win the competition, even if doing so is costly. Such arousal can be experienced in case of heightened rivalries (especially between two bidding parties) and may trigger a “bidding war”. As long as there is clarity that winning a bid can annihilate the competition and prove advantageous to the bidder in the long term, placing a bid higher than the fair value may make sense. However, if competitive arousal takes over, then the bidder may fall prey to personal animosities and may take a rash decision. Other factors that can heighten this “competitive arousal” are time pressures (ex: the timer on online auctions & the shout of the Going One, Going Twice) and the presence of a spotlight (ex: highly engaged audience in live auctions). Parties that recognize the risks of irrational decision making prepare accordingly to mitigate competitive arousal and instead pick & choose the contests to win.
