Several years ago, during one of my business school classes, I participated in an auction for a dollar bill. The rules of this particular auction were fairly simple. The auctioneer (who happened to be our professor) was going to auction off a $1 bill, with all of the students in our class submitting bids in whatever increment we chose. The highest bidder would win the $1 bill, but the auctioneer would receive not only the highest bid but also the second highest bid. For example, if player A bid 10 cents and player B bid 15 cents, the auctioneer would receive 25 cents, player B would receive a net of 85 cents (1 dollar minus the cost of the 15 cent bid), and player A would lose 10 cents. Simple enough, right? Well, as it turned out, the winner ended up paying about $20 for the dollar bill! Don't worry though, the auction was just a simulation, and we were playing with toy money.
This particular game is known as the "Dollar Auction" and was first described by the Yale economics professor Martin Shubik. Shubik published a short 3-page paper entitled "The Dollar Auction game: A paradox in noncooperative behavior and escalation" in 1971. Shubik suggested that the game was best played with a large crowd and further stated that "experience has indicated that the best time is during a party when spirits are high" (whether he meant "spirits" in the usual sense as an emotional state or in terms of alcoholic beverages is not clearly stated).
Let's take a closer look at a simulated game with just two bidders (Ann and Bob) and the auctioneer. Assume that Ann starts off bidding first and bids 5 cents. If the game stops at this point, she has made a net of 95 cents - not too shabby, right? Of course, Bob sees no reason not to try to outbid player A at this point, after all, what 5 cents is mere pocket change. He increases the bid to 10 cents (for simplicity, we will make all of the bids in 5 cent increments). Well, Ann is not going to be outdone by Bob, so she increases her bid to 15 cents. And so on, up until the point when Ann bids 50 cents. Should Bob try to outbid Ann at this point? He reasons that he still can end up making money, so of course he increases his bid to 55 cents. Notice at this point that auctioneer is going to end up with more money than the original dollar, no matter who wins. Remember, the auctioneer will receive the highest bid as well as the second highest bid, i.e. Ann's bid of 50 cents and Bob's bid of 55 cents, or $1.05.
The auctioneer at this point would very happy regardless of the game's outcome, but Ann and Bob are not ready to stop the game just yet. Let's say that the bidding continues all the way until Ann has bid $0.95 to counter Bob's previous bid of $0.90. What options does Bob have at this point? If he bids $1.00, he will of course break even (he will win the dollar bill, but he will have paid $1.00 for it). However, if he doesn't bid, he is certain to lose $0.90 (at this point, the second highest bid). What's he do? He increases his bid to $1.00!
Let's look at Ann's options at this point. If she stops bidding, she will be out $0.95. At this point, she's thinking that there is no way she is going to let Bob win. If she is going to lose money, it's better to lose $0.05 (the difference between the potential winning bid of $1.05 and the dollar that she wins) than $0.95, so of course she is going to increase her bid!
Do you see where this is going? As Shubik writes, "Experience with the game has shown that it is possible to 'sell' a dollar bill for considerably more than a dollar." With just two players, it's not uncommon for the total payment to reach between $3 and $5. I've heard of games (such as the one I played) with multiple players in which the auctioneer walks away with as high as $30-$40!
As Shubik explained, the "Dollar Auction" illustrates a paradox of what is known in economics as rational choice theory, which states that individuals use rational calculations to make rational choices in order to achieve outcomes that maximize their self-interest. In our example above, Ann and Bob are trying to maximize their own self-interests, and in so doing, end up actually losing money! The best strategy would have been to cooperate with each other and stop the bidding after the first bid of $0.05 (they could have split the winnings equally). In a sense, Ann and Bob have encountered a similar situation to the "Prisoner's Dilemma" discussed in my last post. The relatively new field of behavioral economics shows us that we don't live in a perfect world, and in reality, individuals don't always make decisions based upon rational calculations (see, for example, the research by the behavioral economists Richard Thaler, Daniel Kahneman, and Dan Ariely in particular).
The "Dollar Auction" also illustrates two additional concepts, the so-called "escalation of commitment" (also known as the "commitment bias") and the "sunk cost fallacy". I've posted a lot about the "sunk cost fallacy" in the past (see "Know when to fold'em" and "Sour grapes and sunk costs" in particular), which is also known as the "Concorde fallacy" after the fact that the British and French governments tried to make the Concorde plane financially viable based upon the amount of money that had already been spent on the project. Basically, a sunk cost is a cost that has already been incurred and that can never be recovered. Rational choice theory states that we should only take into account the future investment costs of a project, but the reality is that we often factor in the investments that we've already made, the so-called sunk costs. With the "Dollar Auction", rather than cutting our losses early, we rationalize (irrationally I might add) that our best strategy is to continue to up our bid.
Individuals also have a tendency to get into things unwittingly at first and then suddenly find themselves in way over their head! Unfortunately, organizations are also subject to this "escalation of commitment". We tend to continue to overcommit to something, even if it is doomed to fail, when (1) we think there is still something to gain in the future, (2) we are optimistic that we can turn things around, (3) when we have publicly committed or identified with the project, and (4) when we think we can get our initial investment (our "sunk costs") back, even if the project fails.
Barry Staw was one of the first to study the "commitment bias" as it is alternatively called in a number of research studies. One of my favorites was a study entitled "Knee-deep in the big muddy: A study of escalating commitment to a chosen course of action" which involved a simulation where 240 undergraduate business students were placed in leadership positions at a fictional company, Adams and Smith Company, a company that had been profitable for several years until relatively recently. Students were asked to invest $10 million in either the company's Consumer or Industrial projects division. Five years later (in simulation game time!), half of the students were told that their original investment had been successful (the division they chose turned around and became profitable again), while the other half were told that their original investment had failed (the division was continuing to lose money). They were then asked to invest $20 million in either division. Surprisingly, the students whose initial investment decisions were unsuccessful still invested more money in the failing division! Even more surprising, when they were told that their continued employment at Adams and Smith Company was contingent upon the success of their division, they were even more likely to invest the $20 million in the failing division!
The "Dollar Auction" is a really great illustration of both the "sunk cost fallacy" and the "escalation of commitment". As Shubik concluded, "This simple game is a paradigm for escalation. Once the contest has been joined, the odds are that the end will be a disaster to both." And once again, there are numerous examples of similar phenomena in our daily lives. The game's importance lies in the fact that is shows us that we don't always make rational choices, and that it's nearly impossible to take emotions out of our decision-making.
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