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The Winner’s Curse: An Economic Anomaly

May 27, 2013 Leave a comment

My grandfather, William Campbell (1927-2013), played a large roll in theorizing the Winner’s Curse by applying physics equations to economics. The winner’s curse, in simplest terms, is the idea that the winner of a common value auction tends to overpay. Within competitive bidding, the winner’s chances of overbidding increase as the number of bidders, or consumers demanding the item, increases (Investor words).  Each bidder estimates a certain price; some overestimate and others underestimate. The one who overestimates usually wins, and therefore is “cursed” with an item that is not truly worth what he or she estimated for. Such a curse can occur in two similar, yet slightly different ways: the winning bid exceeds the value of the tract, so the firm loses money; or the value of the tract is less than the expert’s estimate so the winning firm is disappointed (Anomalies: The Winner’s Curse).

ImageWhile working for the Atlantic Richfield Company, otherwise known as Arco, my grandfather was summoned to his boss’s office and asked a simple question with a complex answer: how can we save money? After strenuous research and collaboration, the team of engineers and physicists discovered that competition within bidding creates an atmosphere that does not usually allow the winner to truly win. In order to understand such a concept, consider an auction of a piece of land that has five million barrels of oil beneath it. No one actually knows the value of the land; so, some engineers will overestimate the value of the property and others will undervalue it. Most likely, the company that overrated the property will be willing to pay more and thus win the auction. So, we can conclude that within “competitive bidding, the winner tends to be the player who most overestimates the true tract value” (Competitive Bidding in High-Risk Situations). The variable cost of oil does fluctuate as supply and demand increase and decrease, which creates even more risk in an already dicey oil business.

At the same time, the winner’s curse does not necessarily apply to an auction marketplace like eBay. The winner’s curse only applies to competitive lease sales, or an auction with limited supply and excess demand. Marketplaces like eBay and Craig’s List have more supply than demand, allowing consumers to search for the lowest possible price before purchasing an item; thus, producers compete and lower prices. The prices approach equilibrium. Within competitive bidding for a single item, the price cannot approach equilibrium because excess demand disallows such a balance.

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Not so fast

By no means is the winner’s curse a bid strategy; it is a mere analysis on what not to do. However, three simple rules can be followed to avoid being that guy who enthusiastically wins an auction only to watch his property slowly diminish in value: the less information one has compared with what his opponents have, the lower he ought to bid; the more uncertain one is about his value estimate, the lower he ought to bid; and the more bidders (above three) that show up on a given parcel, the lower one should bid.

Supply and Demand in Depth

May 16, 2013 1 comment

The law of supply and demand is a theory explaining the interaction between the supply of a resource and the demand for that resource. The law of supply states that at higher prices, producers are willing to offer more products for sale than at lower prices. It also recognizes that the supply increases as price increases, and decreases as price decreases. Furthermore, it declares that those already in business will try to increase productions as a way of increasing profits. The law of demand says that people will buy more of a product at a lower price than at a higher price, if nothing changes. It additionally states that at a lower price, goods are more affordable and people can, and will, buy them more frequently. Lastly, the law of demand states that at lower prices, people tend to buy less expensive goods as substitutes for more expensive versions; this is also known in economics as the substitution effect. The law of supply and demand presents the effect that the availability of a particular product and the desire (demand) for that product has on price. If there is low supply and a high demand, the price will be high for that good. In contrast, the greater the supply and the lower the demand, the lower the price will be.

An example of the law of supply and demand is the price of oil. According to an article from MPR dated May 16 of this year,

Image“The price of oil has been dropping and the law of supply and demand has boosted gasoline prices to record levels.” The raised price of gasoline, partially caused by the “temporary” shut down of two oil refineries in Illinois, comes from a supply problem. The Chicago Daily Herald explains that “if the price goes up in China, we export our oil. It helps make us richer as a nation but the price goes up and we pay a lot more.” Although we pay more for gas because of this, the bottom line is that there is more money to be made by sending oil overseas. Furthermore, the exporting of oil is what is creating the supply issue. In another article, “U.S Oil Boom to Help Meet New Global Demand” by CNBC, the IEA states that “the shockwaves of rising U.S shale gas and light tight oil and Canadian oil sands production are reaching virtually all recesses of the global oil market.” Despite the high gas prices, the global oil demand is expected to rise 8 percent between 2012 and 2018, further raising the already elevated gas prices. Because America is a growing industrial economy, the rate of oil consumption rises simultaneously with the rate of industrial progression in our economy. New discoveries and improving technologies have increased the amount of oil that can be produced. This innovation could present the idea that it may indirectly raise the prices of gas yet again. Because more oil can be extracted at once, business could use more oil at once, therefore decreasing the supply of oil. However, an article by Floyd Norris of the New York Times states that although demand for oil is rising, “American consumption of oil is expected to be as much as one-third less than it was the last year,” by 2035. This predicted decline of oil consumption depends on how much conservation is encouraged in the years to come. The article goes on to say that the U.S promises include “increasing fuel economy in cars and trucks and at least a small increase in the use of natural gas to fuel trucks.” Furthermore, according to the IEA, if these promises are kept, “oil prices in real terms are likely to be only a little higher than they are now,” but if current policies are continued we will not be so lucky (gas prices would continue to rise rapidly).

In conclusion, the law of supply and demand plays a major role in our economy. It is the strength of a market economy. Because economics is based on the idea that people make choices by comparing the benefits of each option and choosing the most beneficial, the law of supply and demand is a necessary element in determining the price that an item should be. Goods that have a high demand are goods that people believe are the most beneficial options. However, the goods that appear most beneficial may become less beneficial if the demand of them becomes excessive. If there is excess demand of a good, the price of that good is then raised, motivating people to substitute that good for a less expensive option. This less expensive option then becomes the more beneficial one because of scarcity (people wanting more goods than are available) and because of the substitution effect. The law of supply and demand assists the understanding of basic economic ideas and is a crucial theory.

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