Winner’s Curse

Definition

The winner’s curse describes a situation in auctions or competitive bidding where the highest bidder wins but pays more than the item’s intrinsic or common value. This overpayment usually stems from incomplete information, overly optimistic estimates, or emotional and strategic errors among bidders.

How it works

• Many auctions involve some element of common value—the item has one true value that bidders estimate differently. The bidder with the most optimistic estimate tends to submit the highest bid.
• If bidders’ estimates are noisy, the highest estimate is likely an overestimate. When that bidder wins, they “curse” themselves by paying more than the asset is actually worth.
• Behavioral factors (overconfidence, competitive drive, fear of missing out) and informational gaps (hidden costs, uncertain future revenues) amplify the effect.
• In a perfectly efficient market with complete information and perfectly rational bidders, the winner’s curse would not occur. In practice, markets are imperfect and the curse is common.

Origins and common contexts

The term arose from studies of companies bidding for offshore oil-drilling rights in the 1960s–1970s, notably described in the 1971 paper “Competitive Bidding in High-Risk Situations.” It applies broadly to:
– Auctions (art, spectrum, mineral rights)
– Corporate procurement and contract bidding
– Mergers and acquisitions
– Initial public offerings (IPOs), where uninformed or overly optimistic investors may overpay
– Online auctions and competitive consumer purchases

Example

Three companies bid for drilling rights whose true value is $4 million:
– Jim’s Oil: $2 million
– Joe’s Exploration: $5 million
– Frank’s Drilling: $7 million

Frank wins but has overpaid by $3 million relative to intrinsic value. Even if other bidders recognize the price is too high, the auction mechanics award the asset to the highest bid, leaving the winner with the loss.

Consequences

• Financial loss or lower-than-expected returns on investment
• Buyer’s remorse and reputational damage in competitive settings
• Misallocation of resources when winners cannot recoup their overpayment

How to reduce risk

• Perform independent valuation and stress-test assumptions before bidding.
• Set a firm maximum bid (reservation price) and stick to it.
• Seek additional information or use due diligence to reduce uncertainty.
• Use bid shading—bidding below your estimated maximum to allow for informational noise.
• Employ auction design strategies (reserve prices, staggered information disclosure) when possible.
• Prefer contract terms that shift some uncertainty or risk back to sellers (contingent payments, earn-outs).
• Recognize behavioral biases (overconfidence, escalation) and apply precommitment rules.

Takeaways

• The winner’s curse arises when the highest bid reflects an overestimate of value.
• It is driven by information asymmetry and behavioral biases.
• It can occur in many bidding contexts, from oil leases to IPOs to online auctions.
• Practical defenses include rigorous valuation, disciplined bidding limits, and better information gathering.

Reference

• Capen, E.C., Clapp, R.V., & Campbell, W.M. (1971). “Competitive Bidding in High-Risk Situations.” Journal of Petroleum Technology.