Wednesday, October 7, 2009

A Tricky Auction

What would cause someone to bid more than $20 for a $20 bill? Max Bazerman of the Harvard Business School routinely auctions off $20 bills and gets bids above $20. Are the bidders dull? No, they are usually very bright people who have been tricked.

The rules of the auction are simple enough:

– No talking among bidders.
– The first bid has to be a whole number of dollars.
– Subsequent bids have to go up by exactly one dollar.
– No bidder can bid twice in a row.
– The highest bidder pays the bid amount and gets the $20 bill.
– The second highest bidder must pay his or her final bid but get nothing in return.

The last rule is a strange one and it turns out that’s the catch that leads to high bidding. But I’m getting ahead of myself. Imagine a typical scenario:

An adventurous person throws out a bid of $1. Then someone bumps it to $2. This continues until Bob bids $18 and Alice bids $19. Without thinking it through, one might think that the bidding should be over. After all, why bother to bid $20 for a $20 bill. This reasoning applies to everyone but Alice and Bob. However, Bob is in a bind. He is on the hook for $18 and would get nothing in return if the bidding stops.

So, Bob bids $20. Now Alice is in a bind because she would have to pay $19 for nothing if the bidding stops. So she bids $21 to lose only $1 instead of $19. Now Bob must bid again, and so on. The bidding continues until either Alice or Bob relents and decides that the stakes are getting so high that the madness must stop.

Alice and Bob were caught in a trap. It turns out that the best strategy was to not bid in the first place. Even the initial bid of $1 was a mistake. I would hope that most intelligent people who took the time to think through the implications of the second-highest-bidder-must-pay rule would see the problem.

However, this auction would look and feel like a regular auction where it is safe to bid less than an item is clearly worth. This familiarity might lure bidders in before they think things through properly.

The reasons given for otherwise intelligent people overbidding for the $20 bill are things like greed and an irrational desire to win the auction even if it means losing money. While I believe that these factors are very real in many auction scenarios, I don’t think they are the dominant factor here. The bidders were tricked by the extra rule punishing the second highest bidder.

It may be that Bazerman’s demonstrations to open his lectures are an excellent way to introduce the way people lose their heads in auctions, but these $20 bill auctions aren’t really a good example. Even if Alice is rational but figures out the nature of the auction too late, she might make a bid past $20 if she thinks Bob will be the one to end the madness and drop out.

1 comment:

  1. A brilliant experiment. Any bid above $20 is lose-lose, but it's "lose really bad"-"lose minus $20". Anything below $20 is win-lose, and nobody wants to be the loser. Fiendish.