Wednesday, September 28, 2011

The 20 Dollar Auction

Imagine you go to Harvard Business School, and it is the first day of class. Your professor Max Bazerman announces a game: he waves a 20 dollar bill in the air, and offers it up for auction.

There are four rules:
1. Everyone is free to bid
2. Bids are to be made in 1 dollar increments
3. The winner of the auction wins the bill
4. The runner up must honor his/her bid, while receiving nothing in return

Many students sniff out an opportunity to get a 20 dollar bill for a bargain. At the beginning of the auction the pattern is always the same: hands quickly shoot up and the bidding starts out fast and furious, until it reaches the 12-16 dollar range. At that point, it becomes clear to each bidder that he or she isn't the only one with the brilliant idea of winning a 20 dollar bill for cheap. There is a hard swallow, and everyone, except the two highest bidders, drops out of the auction.

Let's say that one bidder has bid 15 dollars, and the other has bid 16 dollars. The 15-bidder must either bid 17 dollars, or suffer a 15 dollar loss. Up to this point the bidders were looking to make quick money; now neither one wants to be the sucker who paid good money for nothing. If they lose, they expect to be ridiculed and embarrassed. So both bidders adopt and commit to the strategy of “playing not to lose”. The action continues. The rest of the class roars with laughter when the bidding goes over 20 dollars.

From a rational perspective, the obvious decision would be for a bidder to accept his loss and back down. But that's easier said than done. The bidders are pulled by their commitment, loss aversion and fear, so they continue to bid. In one case, the bidding stopped at 204 dollars!

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