I feel like I’m a broken record sometimes talking about how much Planet Money sparks ideas for me to write about public policy. But, they’ve done it again. And this time it is around a concept called the “Winner’s Curse.”
Planet Money’s recent story was focused on the re-release of Richard Thaler’s The Winner’s Curse, a 1991 book on a concept he had pieced together in his work pioneering the field of behavioral economics. Since this book was published, Thaler has won the Nobel Prize in Economic Sciences and the field of behavioral economics has gone from fringe to mainstream.
Thaler’s central concept in “The Winner’s Curse” is that there are certain times that bidding wars can push people into irrational behavior. Theoretically, each person should have a specific willingness to pay for a good in a bidding war. Theoretically, a bidding system creates an efficient system of allocation where people increase their bids until their willingness to pay, then do not bid anymore. This means that the person with the highest willingness to pay will then stop on their last bid, receiving the good at the lowest price possible according to the market.
So let’s say you have a “priceless” Dalí painting. Adam really wants it and is willing to pay $3.5 million. Beth wants to buy it as well and is willing to pay $2.9 million. Adam initially bids $2 million. Beth increases the bid to $2.5 million. Adam increases it to $3 million. Beth does not bid any longer, since the price has exceeded her willingness to pay. So Adam buys it at $3 million, receiving $0.5 million in consumer surplus since he would have paid up to $3.5 million.
A problem with this model is the following: why do sellers put their goods up to auction? Ideally, a seller wants to get the most producer surplus possible, which means pushing the buyer as close to her willingness to pay as possible. What benefits does an auction bestow the seller?
Well one problem is an information problem. You will notice that many auctions are for goods with indeterminate value. There is no market for rare Dalí paintings, so we can’t determine what the market value is. So having buyers go to auction over it helps solve that problem.
Another explanation, though, is that auctions may do a different service for the seller. It may induce the buyer to act irrationally.
What if Beth doesn’t stop at $3 million, but instead jumps to $3.5 million to top Adam? Then Adam jumps to $4 million to top her? Suddenly, each of the bidders are above their willingness to pay. Suddenly, the person who wins will end up with the curse of negative consumer surplus from something they will buy and the seller will run away with a bigger payment than they ever could have got without the auction.
This is the curse: how auctions can lead us to act irrationally by playing on our competitive spirits. The win is fleeting: ultimately, the prize is not worth what we pay for it.
What this reminded me of was economic development.
We’ve all heard about it: the exorbitant packages that are given away in tax incentives to lure businesses across borders. When Amazon announced its “HQ2” project, it became the ultimate prize for economic development professionals. Local governments across the country scrambled to offer whatever they could to get into the running, with the winners ultimately stuck with the tab.
The leading national researchers on economic development incentives have concluded that somewhere between 75% and 98% of projects would have been sited in the same place they ended up going to without economic development incentives. That means that in somewhere between three-quarters to nearly all projects, the market clearing price for incentives is zero. All that money that is being spent by most economic development projects is pure producer surplus for the people selling their new development.
Why do cities keep suffering the winner’s curse? A few reasons.
The game is set as a competitive game for economic development professionals. Economic development professionals don’t get rewarded for passing up projects that get too expensive, they only get rewarded when they land projects. This creates an incentive for them to overpay for projects and promise more in the form of deferred tax revenue than the community’s willingness to pay for the project.
A reason this materializes is due to lack of transparency in projects. Often, in the name of securing a “competitive edge,” economic developers who are in charge of creating incentive packages are shielded from the public. This allows them to privilege their own interests over the interests of the public. They will not ultimately pay for giving away too much in deferred taxes: the public will. They will pay, though, if they do not win the development project. This worsens the principal-agent problem between economic development professionals and the public and makes it more likely for developers to fall into the winner’s curse.
This insulation from the public also worsens another problem: a lack of clear, stated goals. If you go into an auction and do not know what your willingness to pay for that Dalí is, you become a sucker for the winner’s curse. You will make “winning” the goal instead of maximizing consumer surplus. Often, economic developers do not have a walk away price or a goal other than to win the economic development project. This predictably leads to them becoming victims to the winner’s curse.
Economic development is not about “winning,” but by pitting different sites within different communities against each other, corporations are able to utilize auction dynamics that ultimately get communities to jack up their offer prices to the point where they exceed the point of marginal social benefits. In the economic development world, the winner’s curse is real. Only by rooting economic development incentives in a framework of social value will economic developers be able to sidestep the winner’s curse and focus on projects that maximize social value. Until then, the economic development world will continue to bear the curse.