The Winner's Curse

In 1971, three engineers at an oil company, Edward Capen, Robert Clapp and William Campbell, published a paper with an uncomfortable conclusion. Firms bidding for the right to drill in the Gulf of Mexico had, year after year, earned less from those leases than their bids implied. The engineers argued that this was not bad luck. It was built into the way the auctions worked.

Consider what was being sold. The oil under a given tract is worth roughly the same to every company, but nobody knows exactly how much is there. Each bidder makes an estimate, and some estimates are too high while others are too low. On average, the estimates may well be accurate. The difficulty lies in who wins. The company that bids most is usually the one whose estimate was most optimistic, which means that winning is itself evidence of having overestimated.

Economists now call this the winner's curse. It does not require anyone to be careless; it arises even when every estimate is made in good faith. The standard remedy is to bid somewhat below one's own estimate, and further below it the more bidders there are, since a larger field makes it more likely that the highest estimate is also an exaggerated one.