The Winner’s Curse

"The Winner’s Curse is something I think about every time I go on E-bay. It was probably first demonstrated by Richard Thaler, who is a very influential behavioural economist at the University of Chicago. We’ve got these economic models, but the problem is these models are based on a profoundly inaccurate view of human nature. So if we get some real data showing us that people aren’t rational agents, shouldn’t we change our economic theories? Again, it’s a pretty academic book, for the most part a collection of papers, but it is fascinating to watch ideas in psychology infecting other fields, like economics, and seeing that infection for the first time in Thaler’s work. So The Winner’s Curse is all about auctions and how people will often over-bid in blind auctions. So if you’re bidding for a free-agent baseball player, or bidding for oil rights, or Bill Clinton’s autobiography, all of these are blind auctions, and people dramatically overpaid – which is a recurring feature of blind auctions. Thaler is trying to take all these canonical examples/problems/situations in economics and saying, ‘Well now we’ve got more accurate models of what people actually do, now we don’t have to rely on these hypotheticals, shouldn’t we revise our models?’ There is still plenty of resistance, some of it well justified. People are saying: ‘Look it’s not like psychology is a very accurate model – the mind remains a very mysterious thing.’ So you don’t want to simply tether yourself to something that’s a work in progress. Which I think is a valid response. I think there are some economists who are very worried about turning economics into a subsidiary of psychology, which is what behavioural economics is: these are economists who use the tools of psychology, use psychological paradigms and combine them with economic models. So it really is a branch of psychology. These are valid worries and concerns but, that said, it’s hard to deny that behavioural economics and neural economics, these two branches of economics that are trying to merge with neuroscience and psychology, are both very intellectual fields at the moment. They’re everywhere, in the Obama administration, there’s now some bigwigs at the University of Chicago. Get the weekly Five Books newsletter This is a booming field, and given where we are right now, trying to recover from a financial apocalypse – yet another financial bubble – I think it only makes sense to once again try to understand what makes us tick. If we have learned anything from the sub-prime mortgage mess it’s that we have yet another reminder that we really aren’t rational agents. When we assume people are rational agents, we are led astray. To the extent that future regulations will be effective, it’s to the extent that they can accurately look at all these irrationalities and anticipate them and take them into account. One example that Thaler uses is the ultimatum game. It’s a very simple game: you give person A $10 and say, ‘OK you can divide it any way you want to, and the only catch is that if person B rejects your offer, then nobody gets anything.’ So economists, with their selfish rational models, would say the way person A should behave is to keep $9 and give person B $1. Person B might think that is unfair, but if they reject it, they won’t even get $1, so rejecting it would be irrational spite. So what’s supposed to happen according to homo economicus is this very rational split. But that’s not at all that happens – when economists actually started playing this game, and they played it all over the world, they found that people on average split $4.50 with person B: they actually made a fairly equitable split. The reason is that they know that if they made an unfair split, person B would be really angry, so angry they’d probably reject the offer. Person A is able to anticipate the emotions of the other person enough for them to make a fair offer. It’s not the way we’re supposed to behave, it’s neither particularly rational or selfish. And yet it’s the way we behave time and time again. In fact, the only people who actually act like they’re supposed to act according to economics textbooks are people with autism. They actually tend to make much more unfair offers."