Game Theory, Vickrey’s Auction and Winner’s curse

“I still feel pangs of remorse over an insidious habit I’ve had since I was a teenager. About three times a week, I attend estate auctions and make insulting, low-ball bids for prized heirlooms until I’m asked to leave.”

-Dennis Miller, American comedian

In Game Theory sometimes the information is incomplete, esp. in case of auctions, in such cases it is difficult to determine intrinsic value of item purchased. Due to incomplete information and emotions we end up paying too much for an item (much higher than the intrinsic value) to win the auction. This is called as Winner’s curse.

Question is how do we avoid this and pay amount which we feel is the true value of item.

Economist Leonid Hurwicz came with concept of mechanism design theory or reverse game theory, wherein markets or institutions like government help you to bridge gap in information between gap in information between buyers and sellers i.e. deal with situation with incomplete information.

One such mechanism was designed by economist William Vickrey. It is called as Vickrey’s auction. In normal auction due to incomplete information, there are chances of person ending up with winner’s curse. Vickrey’s auction is a mechanism designed to avoid this. The purpose is to allow person to pay what he feels is the right price and not get influenced what other person is willing to pay.

Here the person puts his bid in sealed envelope and highest bidder pays what second higher bidder has quoted i.e it is type of sealed bid auction where the successful buyer or seller pays only the second-best price. This mechanism serves as an incentive for the potential buyer to offer a value that is the true value of the item in his or her judgment.

Both Hurwicz and Vickrey won Noble Prize in Economics.