Winner’s Curse

1. Winner’s Curse It’s Everywhere When winning is losing

2. Overview Hopefully you now know how to avoid winner’s curse in a standard auction. But Winner’s Curse and the intuition behind it show up in a lot of different guises. The reason is that it is a common psychological mistake to recognize the effect of strategic actions by others (e.g., sellers / other bidders). When winning is losing

3. M & A In general when one company buys another company, the buyer’s stock price falls. In many of these cases, the buyer admits to paying too high a price. If there is an explicit “bidding war” for the target the auction analogy is obvious. But in many cases, no other bidders are involved. Here the buyer may start with a very high pre-emptive bid to discourage other bidders. Another, related issue is that the current owners often agree to the merger – what should this tell you? When winning is losing

4. Sports Something like a bidding war arises in sports when players enter free agency. This year, the Texas rangers signed Alex Rodriguez to a $252 million contract starting in 2001. In 2001 the Rangers drew some 2,000 more fans than the previous year and finished in the second division. The Mariners—the team Rodriguez left--set a record for wins in a single season. When winning is losing

5. Bank Customers Banks may aggressively pursue another bank’s customers. In most cases it is safe to assume that the customer will bring the more favorable terms offered by the new bank to the old bank. If the old bank wants to retain the customer, it can match the terms. If it doesn’t the customer will go to the new bank Is this a good deal for the new bank? When winning is losing

6. Banks 2. Another problem banks face is that potential customers have an incentive not to inform a bank that it was rejected at another bank. Especially if a bank is known to charge higher borrowing rates, most of its applicants will be rejects from other banks. This also suggests that a new bank (entering a market) faces a heightened winner’s curse. When winning is losing

7. Banks and Scoring This scenario can also explain why banks would move to a quantitative / uniform credit scoring model. All banks would rank a customer the same with these. It may also help to explain the spate of failures of “2nd tier” lenders such as Finova and United Companies (in an increasingly competitive lending environment). When winning is losing

8. The Market for Lemons On October 10, 2001 George Akerloff won the Nobel Prize in Economics. Akerloff’s major contribution is that winner’s curse can actually shut down markets. Consider a world where people can buy new cars or used cars. Used cars are known to be of 2 types: Good and Bad. Half of the used cars are Good and half are Bad. A Bad car is worth $2,000 and a Good car is worth $6,000. It is impossible to tell the two types apart unless you actually buy and then experience the quality. What would you pay for a used car in this setting? When winning is losing

9. Lemons? Experiments show that buyers have a hard time anticipating the strategic behavior of sellers. Again a key is that the seller can turn down an offer to buy. In the absence of gains to trade – or true liquidity shocks (with incomplete markets) -- such settings are likely to give rise to winner’s curses. When winning is losing