The Winner's Curse: Book Review

The Winner’s Curse: Behavioral Economics Anomalies—Then and Now, 2025, Richard Thaler and Alex Imas. Behavioral economics is a combination of economics and psychology, possibly other social sciences. Formal neo-classical models are simplistic and formal, with complex math using calculus. They call for optimizing something, perhaps profitability. In the real world of accounting, I can suggest how to increase revenue and reduce costs, but I have no ability to maximize profit. To optimize the focus is on the benefit to investors, but there are multiple stakeholders including employees, customers, and various definitions of the public. Consequently, I have no problem with challenging these formal models. Economists claim only a single variable can be optimized.

Thaler more or less created behavioral economics, with a shout out the Herb Simon who earlier emphasized “bounded reality,” the limits of human knowledge to make decisions. He suggested satisficing rather than maximizing.

The “winner’s curse” can be the winner of an auction bidding too high, apparently a common practices if oil and gas auctions.

Preface. Economic anomalies are defined as: “empirical observations that were inconsistent with standard economic theory. … Economics is distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences that (eventually) clear. An empirical result is anomalous if it is difficult to rationalize, or if implausible assumptions are necessary to explain it within the paradigm” (p. X). People (called agents in economics) are selfish, meaning they focus on payoffs. I like the term sociopathic.

Some standard economic games like Cooperation and Ultimatum games show that people are usually not “selfish money maximizers.” There are risk preferences and risk aversion assumption. Loss aversion seems to be useful. Losses hurt more than gains give pleasure.

Chapter 1: The Winner’s Curse. Start with a jar filled with coins and auction it off. The average bid will be made by risk averse people and be much less than the coins’ value. The winning bid will exceed the value of the jar: the winner’s curse. Oil companies bid by auction of government property for rights to drill. The average amount is typically less than experts predicted based on their opinions of oil expected. The winning bid usually was too high, probably based on optimistic estimates—the winner’s curse. Question: What is rational? One explanation was the “hubris hypothesis.” “The winner’s curse appears to be a common and robust phenomenon” (p. 3). In economic terms there were systematic errors.

 Other examples include mergers and acquisitions. The acquirer must pay more than the market value of the target to get approval, usually a substantial premium. One problem was asymmetrical information, with the target making selling decisions on more complete data. Experiments with graduate students produced similar results, especially as competition (more bidders) increased. In book publishing, most auctioned books do not earn their advances. One strategy was to make lots of low bids, which were occasionally successful. Finally, is the annual draft in the NFL of new players, with early picks getting “less performance per dollar spent” (p. 19).

Chapter 2: Cooperation. Economics and game theory assume people are selfish and rational. Game theory’s prisoner’s dilemma, a strategy when two crooks are caught and if each stays quiet (cooperates), they receive short sentences. If one defects, he goes free and the other convicted. If both, they receive long sentences. Confessing is considered a dominating strategy, favoring rationality and self-interest, just a bad outcome.

Public goods can be provided for all (it is costless after being provided for one), and others can use the public good, like a public park. Other examples include public radio and TV. People can “ freeride,” a type of rational selfishness. People vote although the individual vote has little effect on the outcome. Experiments called group exchange allows players to invest in public goods versus take it home. The money invested is redistributed after increasing the return.  The socially efficient allocation (all funds in public goods), but the selfish strategy is keeping it all.  That reduces the total pot, but the individual does better. The free rider creates a social dilemma. Experimental results in 40-60% contributions. One paper was “Economists Free Ride: Does Anyone Else?”

There is reciprocal altruism: kindness and cooperation are reciprocated, as is hostility. The norm of cooperation is selfishly rational in the long run (only an economist would call that selfishness), tit-for-tat. People tend to cooperate until experience shows they are being taken advantage of. Pure altruism is taking pleasure in others’ pleasure (“the pleasure of seeing it,” according to Adam Smith). Impure pleasure is the act rather than the outcome. Greed is often associated with free riding. Talking to one another inspires cooperation. “The supply of cooperation is upward sloping” (p. 39). Most people are not self-interested jerks.

Chapter 3: The Ultimatum Game. “Do unto others as you would have them do unto you—unless you already know they are scoundrels” (p. 46). The Proposer has a sum of money to share and makes an offer. The Responder can accept or reject (then both get nothing). Economists claim the Responder will accept any positive amount. People most often propose 50-50. The mean offer was 32%, with about a quarter rejected. The primary reason to reject it was lack of fairness. If the offer was huge like a million bucks, responders were more likely to accept a small percentage (say $100,000).

In the Dictator Game the Allocator makes the decision, period. Allocators usually offered substantial percentages. This is similar to a monopolist’s position. Fairness continues to be a major consideration, like raising the price of a new car above list price. “Most people prefer more money to less, like to be treated fairly, and like to treat others fairly” (p. 58).

Chapter 4: The Endowment Effect, Loss Aversion, and Status Quo Bias. “Demanding much more to give up an object than he would be willing to pay to acquire it—is called the ‘endowment effect’” (p. 65). Tversky and Kahneman call this loss aversion. This makes a market transaction difficult, the “status quo bias.” One experiment involved giving participants a coffee mug from the local college, which costs $5. Ronald Coase developed the Coase theorem, that the $5 was the value, period. But experiments show that many would not part with the cup or only willing to sell it at substantially more, called “loss aversion.” Choosing a college could be another example, choosing one over another. There are difficulties in cost-benefit analysis and offers of compensation which can be interpreted as bribes. Collectors have an endowment effect, dealers do not.

Thaler’s “nudge” can overcome inertia, like automatic enrollment in retirement plans. Also, subscriptions and memberships. Tversky: “there was once a species that did not display loss aversion, but they are now extinct.”

Chapter 5: A Primer on the Psychology of Risky Decision Making. How do people make decisions in uncertain situations? Nicolaus Bernouille proposed the St. Petersburg Paradox in 1713. A coin flip in a casino wins 2 ducats if it comes up heads. If she wins again, the prize doubles to 4 ducats, and so on. The game ends when tails come up. How much should the person pay for this opportunity? The expected value (amount won times the probability) is infinite. However, people have diminishing marginal utility because they are risk averse. Mathematicians von Nuemann and Morgenstern developed expected utility theory which led to Game Theory. People want to maximize expected value. But how do people actually behave?

This led to Tversky and Kahneman’s Prospect Theory, based on choosing between bets based on probabilities. Like: “choose between $1 million with certainty, or $5 million with a probability of .1, $1 million with probability .89, and $0 with probability .01.” Then they restated the problem, both options with probability (not certainty). People usually preferred the $1 million with certainty but switched when uncertainty was always involved. They stated other paired scenarios and developed a descriptive theory. People do not want to gamble in their developing wealth (certainty effect). They have a reflective effect and make risk-averse choices but make risk-seeking choices when presented only with losses, violating expected utility theory. A value function replaces the utility function. The result is loss aversion (“people like gains, but hate losses more,” about twice as much). Plus, what’s called diminishing sensitivity (risks flatten out).

Chapter 6: Be Careful Before You Call Something Risk Aversion! Despite the anomalies like Tversky and Kahneman, risk-averse expected utility theory remains the classic. There is myopic loss aversion and focus on short-term fluctuations like in the stock market. If I win say $20 on a slot machine that becomes “house money” which I’m willing to gamble away.

Chapter 7: Choosing Between Now and Later. Adam Smith noted in The Theory of Moral Sentiments: “The pleasure which we are to enjoy ten years hence, interests us so little in comparison with that which we may enjoy today.” These are called intertemporal choices, choices about timing. Capital market data were conveniently testable, including the potential use of arbitrage (buy at one price and sell at another price, expecting it to be higher). Samuelson introduced the Exponential Discounting Model. A gift today is worth more today that a gift a year from now. It can be discounted using the appropriate interest rate. There are examples of violations (to economists) like taxpayers overpaying to the IRS to get a refund at year-end (an interest-free loan). “An anomaly in labor markets—wages rise with age even when productivity does not” (p. 142). Savoring is anticipating future outcomes. Consume gains, postpone losses. There is a “present bias.”

Chapter 8: Savings, Fungibility, and Mental Accounting. Modigliani developed the life-cycle theory as the standard model of saving for retirement, solving for optimization. This is based on present value of financial wealth, the needed annuity, then consume the amount of the annuity. Myopically, consumers just spend their income each period. Income and wealth are fungible, but annual consumption is excessively sensitive to current income. Either method works. Social Security is a mandated form of government control for retirement.

There is a distinction between realized and paper gains, like in the stock market. People usually do not consume their unrealized capital gains. In fact, for most wealth consists of pension and Social Security wealth and home equity (and perhaps future income). Since IRAs are illiquid, this is a form of self-control. There can be self-imposed rules like aversity to debt.

There is a “sunk-cost fallacy,” the likelihood of “throwing good money after bad.” An internal arbitrage opportunity is people with outstanding balances on credit cards and savings accounts. “The primary reason the ‘rich get richer’ is they own more stocks and don’t consume their capital gains” (p. 180). IRAs replaced defined benefit pension plans, but this required employee engagement. Employers could make this automatic (nudge) unless the employee opted out.

Chapter 9: Preference Reversals! Economic agents choose rationally. Do people like logical consistency including transitivity? There is preference reversal, like gambling. Buying and selling gambles correlated with payoffs rather than chances of winning.

Chapter 10: Utility Maximization.  Agents try to maximize utility. Decision utility is based on revealed preferences. Decisions are based on expected future utility, called hedonic forecasts. “The net outcome of substitution is a directional bias, known as anchoring. … Forecasts of future hedonic and emotional states are anchored in the current emotional and motivational state. The outcome has been labeled a projection bias because consumers are seemingly projecting their current mental state onto a future one” (p. 202). This includes a “hot-cold emotional gap.” People should learn from the past, but there are several sources of bias, including “duration neglect.” There is the cold-water experiment. Or colonoscopy.

Affective forecasting: changes to improve happiness. “Nothing in life matters as much as you think it does while you are thinking about it. … Climate is more important in affective forecasts than in actual well-being. … People often adapt surprisingly well to important changes in their lives” (p. 208). These can be exaggerated. To maximize utility start by forecasting possible outcomes; hopefully, they are not systematically biased.

The choice of a university can affect long-term earnings, social networking, and potential marriage partners. Even whether or not to go to college.

Chapter 11: A Brief Digression on the Efficient Market Hypothesis (according to Eugene Fama). This is the study of asset pricing. Efficient markets assume that stock market prices are correct. It should not be possible to predict changes with available information, also called random walk. Thaler showed that long-term changes in past prices did predict future long-term returns, based on portfolios of the biggest winners and losers. The portfolio of losers outperformed the winner portfolio. Several factors predict returns. On the other hand, most professional portfolio managers fail to beat index funds.

Chapter 12: The Law of One Price. After the law of supply and demand (to determine price sold at some (efficient) quantity is the law of one price: identical goods must have identical prices. The reason is arbitrage, immediate buying and selling of the same security. This is generally true with some exceptions like “closed-end” mutual funds and sometimes “country funds.” American Depository Receipts (ADRs) are shares of foreign securities held in trust by US financial institutions. Arbitrage should limit their price differences, but there have been exceptions, like Royal Dutch Shell (Royal Dutch versus Shell).

Corporations can also spin off subsidiaries, which includes “equity carve-outs.” Long-term Capital Management was a hedge fund with extreme “convergent trades” which diverged rather than converged and the company had to liquidate. Taiwan Semiconductor Manufacturing sells at different prices in Taiwan and New York (“Totally Stupid Market Chaos”).

Epilogue. Famous economics like Samuelson, Arrow, and Hicks added mathematical rigor to economics, creating rigid models that could diverge from reality like “rational expectations.” Prospect theory came from psychology,

demonstrating specific types of differences. Herb Simon introduced “bounded rationality,” limits on decision making. Thaler identified multiple anomalies. Tversky and Kahneman introduced systematic bias as judgments departed from rational benchmarks through Prospect Theory. Question: what makes a choice difficult? In economics the expectation is optimization, which has multiple problems. People “satisfice” instead, like using a rule of thumb.