Auction Theory : Winner's Curse

In common value auctions, the good being sold has the same actual value for all bidders, but each bidder receives only partial, private information. A classic example is the auction of oil drilling rights, where each firm evaluates the value of the field based on a single geological sample. Since all firms operate with incomplete and distinct private signals, the true value of the good is best approximated by averaging all signals—an average no bidder actually knows.

Firms often use their own signal and assume others' signals to be average, leading to an overestimation of the good’s value. When each firm bids based on this naive expectation, the most optimistic bidder tends to win. However, winning reveals that the bidder likely had the highest signal, and thus, the others had lower ones—implying the actual value is below expectation. This results in a systematic overpayment known as the winner’s curse.

The curse emerges because bidders fail to condition their valuation on the event of winning. Rational bidding must account not just for the signal received, but for what winning implies about the information held by others. If bidders adjust their expectations downward—conditioned on winning—they can avoid losses.

Yet, in practice, this adjustment often requires experience. Inexperienced participants in new or opaque markets, such as sports team managers bidding for players, commonly fall into this trap, overpaying due to unadjusted optimism. The winner’s curse thus reveals how information asymmetries and cognitive biases can distort outcomes even in competitive environments.

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