Dollar Auction Paradox: Understanding why companies spend more than what they can potentially earn and why we pay more than the actual value of a product?
Article: Dollar Auction
A dollar auction is a simple game where participants bid for a dollar bill, but with a twist that both the highest bidder and the second highest must pay their bids. Assuming all the participants are rational, what will the winner end up paying for the bill?
Initially, bidding seems harmless and potentially profitable. However, as the bids approach the one-dollar mark, a dilemma unfolds. For example, Participant A bids 90 cents, and Participant B counters with $1. At this point, Participant A faces a choice: bid $1.01 and lose only 1 cent or withdraw and lose the 90 cents already bid.
Why did they bid over a dollar for just a dollar? Bidding more than a dollar for a dollar is not logical. At the same time, losing 90 cents is not as smart as losing 1 cent. As the bids escalate, participants shift their focus from gaining profit to avoiding significant losses. This shift in perspective often leads to bids far exceeding the dollar's face value. This consequence is coined as "escalation of commitment" by the economist Martin Shubik in his 1971 paper to highlight a paradox of rational choice theory. Surprisingly, in a study involving Harvard MBA students, winners even paid up to 20 times more than the face value of the bill!
Examples of the dollar auction game can be seen very often in the real world. Winner-takes-all markets, such as consumer internet with network effects, often create an environment similar to the dollar auction. However, unlike the dollar auction game where only the second-highest bidder loses, all players participating in the market, like consumer internet, will end up with high losses if they don't win. Similarly, bicycle-sharing startups engage in intense battles for market monopoly, resulting in massive losses for all but the eventual winner.
The Dollar Auction Paradox reveals our tendency to escalate commitment irrationally in competitive situations. Ironically, the most effective way to win at a dollar auction game is by not participating in one. Therefore, we should avoid getting caught in a costly bidding spiral before joining a competition.