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What Investors Can Learn from eBay Bidders

New research shows auction buyers sometimes overpay: rational ignorance

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auction-behaviourEveryone wants to pay the lowest price possible for what they’re buying. That’s one reason consumers have flocked to online auction websites like eBay looking for deals. Consumers can choose to bid in competitive auctions, or to pay buy-it- now prices posted by independent sellers of the same item. Some striking recent research has shown that some eBay auction winners end up paying more than the lowest buy-it- now price offered by sellers on the same website! Dubbed the “bidder’s curse”, this looks like a clear-cut case of irrational behaviour.

In our recently released working paper written jointly with Philipp Reiss, we argue that bidders’ apparent inattention to the posted prices of other sellers may be a rational response to the time and effort to find other sellers for a good.

We show that if bidders rationally account for their costs of acquiring information about different sellers of a good, then they won’t always look around for other sellers. A result of such rational ignorance is that even a rational person will sometimes end up placing a bid that exceeds the price offered by another seller for the same good. The opportunity cost of doing the research to avoid overpaying may be too high for research to be worthwhile.

But we know that people aren’t always fully rational and may have trouble accounting for “opportunity costs”.  Unfortunately, we can’t observe eBay bidders’ opportunity costs of looking up information on other sellers. To address this limitation, we design a laboratory experiment to test whether the opportunity cost of looking up the price from another seller can account for the bidder’s curse.

In our experiment participants bid for a fictitious good that is available both in an auction and at a posted (buy-it- now) price. Each participant can look up the posted price before bidding in the auction, but doing so requires forgoing an opportunity to earn money in another task. Thus, each participant faces a trade-off between the opportunity cost of looking up the posted price (the money they could make doing the other task) and the expected savings from making an informed bid. We systematically vary how much this second task pays, which allows us to study how opportunity costs affect information acquisition and bidding behaviour.

Our experiment reveals a substantial number of bids above the posted price – consistent with evidence from eBay. It shows that such bids are mostly made when a participant chose not to look up the posted price of the object, which in turn occurred more often when the opportunity costs of doing so were higher. This corroborates our prediction that rational ignorance drives overbidding.

We think that our results may be useful for thinking about anomalies in markets more generally. When opportunity costs aren’t observed, behaviour that looks irrational might in some cases be a response to the opportunity cost of acquiring the information needed to make a decision that looks rational to an outside observer. For example, many people pay financial advisors or invest in high fee mutual funds even when they could obtain the same portfolio for a lower fee if only they were willing to do a bit of their own research and manage an account at a discount broker.

Opportunity costs are sometimes tricky to observe and hence easy to ignore. Our experiment shows that people are nevertheless responsive to them, and that the opportunity costs of making optimal decisions can help us understand some of the seemingly sub-optimal behaviour we see around us. Download the full paper.

 

David Freeman and Erik O. Kimbrough are professors at Simon Fraser University

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