May 6, 2010

$20 Bill Auction

I recently caught an episode of Nova on PBS called Mind Over Money.   It was a very interesting episode that talked about rational versus irrational forces that drive people to make the decisions we make regarding money and economics in general.  You can watch the full episode online if you want.

One of the examples they had in the episode was an auction of a $20 bill.   They had a $20 bill they auctioned off starting at $1 bids.   The rule of the auction was that the highest bidder would get the $20 for their winning bid BUT the 2nd highest bidder would receive nothing but also pay the amount they bid.   The auction ended at $28.   Why?   The individuals made what seemed like rational choices choosing to bid the auction up to $19 because if they won they'd be making a profit.  But the 2nd highest bidder at any point had an incentive to bid even higher so they wouldn't be stuck paying their losing bid and getting nothing.   So if I bid $18 and then I'm outbid by $19 then I will go ahead and bid $20 so that I can break even and not loose $18.  Then my competitor is faced with either losing $19 or bidding $21 and taking a net loss of $1.   This then goes back and forth in a game of chicken until one of the bidders just gives in and takes the loss.

To see this game of chicken eventually happening each bidder will have to think several steps ahead.  Or they could avoid the whole trap by never bidding in the first place.

But where do you stop bidding in order to cut the losses and maximize the profits??   The ideal bet is $1 and stop.   That way you win $19 and nobody else loses anything.   But the other guy will likely want to take the risk and bet $2 and hope that he wins thus profiting $18.   Now you're losing $1.  You might then take the risk to bid $3 and hope you win.

The whole idea is discussed in the wikipedia article on the "Dollar Auction".   They talk about an auction of $1 but but a $20 bill auction is the same principle.

I found it a very interesting situation to think about.  Of course its a very fictional idea.  Theres never any real world situation where you can bid on something and have to pay the money and get nothing in this way. The closest scenario I can think of is casino gambling where you wager money and face winning or losing, but there your losses are limited to no more then the amount you wager at any given point.

But the emotional greed and desire to not take losses that drives the $20 bill auction up is the same emotional reactions that cause markets to go up and then crash in a classic speculative bubble.  People bid up the $20 first cause they hope to profit, then they keep hanging on desperately even though they face a loss simply because they don't' want to eat the loss and hope to hang on for some sort of profit.    When a speculative bubble happens people initially ride the bubble up in hopes of profit then they ride the collapse cause they are hanging on in hopes of not eating the loss.

The Nova episode talked about some other examples of irrational money choices that people make.  If that kind of thing sounds interesting then I'd recommend watching the entire episode.

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