Why would anyone pay more than $10 for a $10 note. It seems crazy, right?
In 1971, economist Martin Shubik published a paper describing a parlour game called the Dollar Auction. The Dollar Auction is an auction with an ingenious set of rules that results in people bidding a lot more than $1 to win the auction. The purpose of this game is to illustrate how thoughtful, rational behaviour can sometimes lead to negative outcomes.
How does the Dollar Auction work?
To help illustrate how a Dollar Auction works, I’m going to add inflation and rename the game: The $10 Auction.
Here’s how it works:
- The auctioneer has a $10 note that he puts up for auction.
- Participants in the game place bids for that $10 note, just like they would in any other regular auction.
- When the bidding finishes, the person with the highest bid hands over his bid amount and takes home the $10 note.
Sounds simple right? Here’s the catch!
The player with the second-highest bid also needs to pay the auctioneer their bid amount. But rather unfortunately for them, they don’t get to keep the $10 note.
Let’s role-play how a $10 Auction might go
The auction opens the auction, and someone places a bid for $3.
A $10 note for $3 is a steal, so someone else bids $4.
Another person in the room raises again to $5 and the auction continues.
Various other people place bids as we start to inch closer to the $10 mark.
Now there’s only 2 active players left in the auction. Let’s call them Andrew and Brittany.
Andrew bids $8
Brittany counters with $8.50.
With Brittany having the highest bid, it is clear to Andrew that if the auction were to end now, he himself would have to pay $8 to the auctioneer for no prize. Therefore, Andrew knows he needs to be the highest bidder.
Andrew bids again, pushing the bid to $9.
Andrew & Brittany both keep bidding against each other, the bid amounts becoming smaller and smaller as they approach $10.
Andrew has the higher bid of $9.95 as the magical mark approaches.
Brittany bids $10.
What does Andrew do now?
Being the second highest bidder, Andrew knows that if he folds now he will be paying $9.95 for nothing.
Andrew bids again, pushing the highest bid to $11.
Wait? Huh? This is not logical! Andrew and Brittany are now bidding more money the amount that they stand to gain!
Now, even if Andrew wins the auction, he will still end up behind, by $1. But that’s nowhere near as much of a deficit as Brittany, who is now on the hook for a $10 gift to the auctioneer.
Brittany realises this, so she places another bid for $12.
Being only $2 behind is much better than losing $10.
And so, Andrew and Brittany keep bidding, losing more and more money as the auction goes on.
How far does the auction go?
The $10 note is now no longer worth just the $10 printed on the front. It means something more. It represents victory.
While a sense of competition may cause Andrew and Brittany to keep bidding out of a sense of pride, this feeling won’t last forever.
As the highest bid approaches three-times the $10 note, the motivation to continue diminishes rapidly. The proportional difference in loss between the two players becomes smaller and smaller and eventually one of the two bidders bows out.
What a beautiful experiment in human competitiveness. A textbook study in irrationality.
Without a doubt we can say that the winner of the Dollar Auction is the auctioneer themselves.
What can we learn from the Dollar Auction?
While there are many lessons to be observed in the game, one of the main learnings I’ve taken is the power of ‘sunk cost’. The more time, money or energy we have invested into something, the more averse we are to stopping ii prior to its completion.
Three weeks ago I started watching a Netflix series, but had mostly lost patience with it after four episodes. With only two episodes left in the series, I reasoned with myself that I had come too far now to quit. Those last two episodes represent two hours of my life that I will never get back.
A common workplace example of sunk cost, is the customary desire to complete a project at any cost, even when the business case weakens below acceptable tolerance.
Next time you are watching a boring TV series, or deciding whether to commit another round of funding to a doomed project, recall the Dollar Auction and consider how high you would be willing to bid for that $10 note.