Winner’s curse – definition and meaning
Winner’s curse refers to one of the hazards of being a victor in a number of different business situations. For example, when a company successfully bids for a supply or construction contract, the curse refers to the money it will lose because it significantly underestimated the overall cost of being the supplier or builder.
The term winner’s curse is sometimes used in auctions when the successful bidder for an item overestimated its value – the winner paid too much.
Winner’s curse may be the result of emotions, incomplete information, a simple miscalculation, or a number of other factors regarding either the item being auctioned or the project that went out to tender.
Bidders may sometimes find it hard to accurately determine a project’s total cost or an item’s intrinsic value.
Consequently, the successful bid is the one which overestimated the value of an item being auctioned or underestimated the cost of a project that was put out to tender.
According to MindYourDecisions.com:
“Sometimes winning comes at too high a cost. In such cases, it is the winners that are the real losers. The phenomenon is known as the ‘winner’s curse’ and it affects a wide variety of situations, from baseball free agency signings to stock market IPOs.”
Example of winner’s curse
Imagine you supply orange juice to shops and supermarkets. Mary Smith Inc., the largest supermarket chain in your country, asked for bids to supply the chain with Mary Smith brand orange juice for 2 years.
If you got this contract, it would be the largest one you had ever signed. You carefully costed your offer, and tried to estimate what your rivals would include in theirs. You then reduced your offer price by 10% in order to outbid the competition.
Your strategy worked; you got the contract. However, you only had a profit margin of 3% in your sales. This left you extremely vulnerable to changes in the global price of oranges.
One month later, a Category 5 hurricane hit the Caribbean and much of the orange-growing region of Florida. Then, a record drought considerably undermined orange production in the state of São Paulo in Brazil. Eighty-five percent of global orange juice production comes from Florida and São Paulo.
The price of orange juice rose by 15%. For the rest of your contract period with Mary Smith, you would be selling at a loss. This loss was your winner’s curse – you had underestimated the cost of your raw material – orange juice.
Winner’s curse – many possible situations
The term can be used in many different business situations, not just auctions or when bidding for a contract.
TechTarget explains that winner’s curse – in a negotiation – is an offer that is accepted straight away by the other party. The term suggests that although the offer was accepted, the party making that offer did not get the best deal possible.
When referring to negotiations, Negotiations.com has the following definition:
“[Winner’s curse] occurs when an under aspiring negotiator sets their target or aspirations (goals or objectives) too low at the outset of a negotiation and is granted an immediate agreement by their negotiating counterpart.”
In Initial Public Offerings (IPOs)
An IPO (initial public offering) occurs when a private company – one that is not listed in a stock market – becomes a public company – one that is listed in a stock market; it is floated.
In an IPO in which the bidders need to estimate what the market value of a company’s share will be, there is a risk of winner’s curse.
If I purchased lots of shares during the IPO of John Doe Corp., and I overestimated what the value of that stock was going to be, I could lose a lot of money. My successful purchase of those shares came with a curse; hence the term.
Generally, inexperienced investors, those with less information about what they are deciding on whether to buy, are at higher risk of winner’s curse compared to large financial institutions, which have teams of researchers gathering data.
Video – What is Winner’s Curse?
In this video, Dr. Hank Lucas, who works at the Smith School of Business, part of the University of Maryland, explains what ‘winner’s curse’ is, and when and why we might sometimes be better off losing.