Richard Thaler and The Winner’s Curse

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Hello and thanks for downloading the More or Less podcast. With a program that looks at the numbers in the news and in life and speaks to legends of behavioural economics.
I'm Tim Harford.

Once upon a time, economics was a simpler kind of game. Human beings were said to be rational beings, optimizing their way through life, a wealth-maximizing version of Star Trek's Mr.
Spock.

That made them much easier to describe in mathematical models, and who knows? Maybe it was basically true. But what if humans are less Spock and more Homer Simpson?

Silly, impatient, weak-willed, and easily confused?

That was the argument of a few iconoclastic economists who in the 1980s made this argument based on results results from experimental psychology along with a big old dose of looking around at real people.

And if these rebel thinkers, the behavioural economists were right, wasn't that kind of important for how economists did their work and how public policy should be conducted?

One of those pioneers was Richard Thaler, who noted down some of these anomalies in a column in the 1980s, which was turned into a book, The Winner's Curse, first published in 1992.

His work also won him the Nobel Memorial Prize in Economics in 2017. More than 30 years on, he's returned to that book, publishing a new, updated version with co-author Alex O.

Emos, which looks at whether those anomalies in rational thinking have stood the test of time. I'm joined in the studio by Richard Thaylor.
Hello, Richard. Hello, Tim.
It's so nice to see you.

It's good to see you as well.

We should start by exploring some of these ideas.

Maybe the book title, The Winner's Curse. What is the winner's curse?

The winner's curse is the following.

Suppose you have an auction. Imagine here's the way we do this in a classroom experiment.
We fill up a jar of jelly beans. We say the jelly beans are worth 10 pence each.

And then we auction off the jar.

You don't get the jar, you get the value. Yeah.
And we don't know the value because we don't know how many beans. Right.
So we all make a guess.

And what happens if

a professor is low on cash, this is a good demonstration to run. The average bid will be less than the amount in the jar, but the winning bid almost invariably is more than the value.

Yeah. Because by construction, the winning bid is the highest bid, right? Well, by construction, the winning bid is the highest bid.
That's correct. And the highest bid is likely to be above.

And the more bidders there are, the more likely it is that the winning bid is too high. Yeah.

So you have, let's say, $10 worth of coins in the jar, and you've got 50 students, and they're all bidding away, and the average bid is, whatever, $7.

But there's one or two people, and you only need one. You only need one.
Who bids $20, $30. Yeah.
And you've made your profit.

So this is a unique example in the book because it was not discovered by psychologists or economists. It was discovered by engineers working for the Atlantic Richfield Oil Company.

So the government would divide up the land into various plots

and auction off the right to drill right there.

And they had scientists say how much oil they thought there would be.

Which is a bit like the beans, right? Because nobody really knows how much oil there is. Everyone takes a look and has a guess.
And then later you find out.

And like the jar of beans, it's in principle worth the same to everybody. Yeah.
So if Exxon or Royal Dutch or whatever gets the rights, there's going to be the same amount of oil down there.

So what they found was that on the leases they won, there was less oil than they expected.

And they thought, gee, we thought we had great geologists. What's wrong here? And the insight they had was the insight you mentioned earlier, which is, well, it's not a coincidence

that

we won this. We won this because we made the highest bid.

And the highest bid is not a random bid.

So the mathematics of this is that

the value you should expect if you're the winning bidder is lower

than it would be if you had made some other bid, because the fact that you had the high bid means there's a good chance that you had an overestimate of the value.

Let's talk about a more everyday

example. There are loads of examples in the book, but one that really fascinates me, always fascinates me, is this idea of mental accounting.
So tell us about mental accounting.

Economists have many simplifying assumptions. One is

that

money is fungible. It's a sort of fun word.
Fungible means that it doesn't come with any labels. Yeah, dollar is a dollar.
A dollar is a dollar.

Seems like not an unreasonable assumption, but okay,

but you're going to tell me it's wrong. So real people don't don't think all money is the same.
You know, for centuries,

people adopted a strategy of putting

cash into envelopes or jars with labels

as a way of budgeting. Think of it as their early spreadsheet.
Yeah,

this is rent money. This is food money.

This is the electricity bill.

Right.

And if you look at the way real people behave, they treat money differently depending on how they got it and where it's stored.

So, for example,

money in your house is house money.

This is like the equity in your home.

You own your home, and it's worth a certain amount of money.

And even

when

people get old and retire and maybe move,

they still don't draw down the money in their home.

If they move to Florida or Spain, they buy a house with the money, the equity in the existing house.

During the financial crisis, the price of gasoline fell by 50%.

All of a sudden, people have extra money in their gasoline budget. So economic theory says, well,

there's an income effect and a substitution effect. So you're a little richer.

So you spend a little bit more on everything.

And gasoline is cheaper. So maybe you take a bit more road trips.

What did people do? They did those two things, but they also, oddly, treated their cars to occasional fill-ups of more expensive gasoline. Yeah.
Because you got all the money in the gasoline account.

Yeah. What are we going to do with that? You know, how many times can we go visit grandma? I would have gone for better olive oil or better wine.
You know,

that would be my advice.

The field of behavioral economics now is mostly done with millions of people shopping in real places, not relying on lab experiments.

But the good news is that the lab experiments I reported 30 years ago all replicate.

And in fact, my co-author has provided a website where anybody can replicate any of the experiments at home for fun, if that's your idea of fun. Yeah, no, well, why not? It would be.

Try it. Yeah, exactly.

Thank you so much, Richard. It's been a pleasure, as always, too.
I've been talking to Richard Taylor, the co-author of The Winner's Curse. And that's all we have time for.

But please keep your questions and your comments coming in to more or less at bbc.co.uk. Until next week, goodbye.

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