The Winner's Curse

by David Marasco

It's the middle of winter. Right now GMs are hitting the phones talking to player agents, trying to sign the men they think will push them over the top next season. The fans enter the season with great expectations. Yet so many times the player thought to be a savior to the team ends up not being worth the money it took to sign him. Is it because free agents go lose their edge after signing their big-money contracts? Seeing as many of these guys were set for life before they switched teams, this explanation doesn't seem to work. To find the real answer, we have to drill for oil.

Back in the 1950s the players in the American petroleum industry turned their eyes to the Gulf of Mexico. With newer technology it was possible to drill offshore. So the race began and the oil companies bid for drilling rights and set up operations. There was only one problem. These offshore oil wells weren't turning a profit. Is drilling on the seabed harder than drilling on dry land? Sure, but that wasn't the difficulty. The real problem was the bidding process given the uncertainties in information available to the oil companies. This was explained in an article published in the Journal of Petroleum Technology titled "Competitive bidding in high risk situations," by Capen, Clapp and Campbell of the Atlantic Richfield Company (ARCO) in 1971. Here they coined the term "winner's curse."

Suppose you have four oil companies all interested in the same patch of offshore property. Back in the 1950s the methods available for determining the amount of liquid gold under a few hundred feet of water were primitive. This led to a large spread in the estimations of the value of the oil, and hence the drilling rights. Suppose that after all the costs of drilling were accounted for there was $10M worth of oil in the ground. Company A might determine that there was only $5M worth of oil. On the other hand, Company B might nail it at $10M, Company C could value the oil at $12M and Company D could make a gross overestimation and believe that there was $20M worth of oil in the ground.

Now we come to the bidding for the drilling rights. At $5M, Company A drops out of the competition. At $10M, we lose Company B. At $12M Company C bows out, and Company D is very happy because they have paid $12M for property they believe is worth $20M. But since there is only $10M worth of oil in the ground, Company D is in the red for $2M. They have suffered the winner's curse. In an auction, the prize goes to whoever has the most optimistic view of the value of the object being bid upon. In many cases, this also means that the winner is the person who has overestimated the most.

Is a baseball player really like an oil well? He is in that some estimation to his value can be made with the data available, but his future value (what the owners are bidding on) is in many cases an open question. How much will a thirty-year-old outfielder with a .280 batting average and 30 homers a year be worth over the span of his next contract? $5M a year? $7M a year? It's hard to guess, especially when the future free-market value of his competition is factored in. How fast will the average salary rise over the next three years? (Note that the oil companies need to make a similar calculation - they need to not only estimate the amount of oil in the ground, but they also have to make an estimation of the future price of oil) It's easy to see how several different teams could make very different estimations of the value of this player. And the team that signs him in the end is the team that was the most optimistic about his value. Like an oil company, this optimism could leave them well in the red.

So what solutions exist to the winner's curse? Information and caution are two big factors. Improving technology allowed oil companies to get a better grasp on how much oil is in the ground. Obviously a company that had better information made smarter bids, and was less likely to overbid. After the winner's curse phenomenon became better understood, oil companies were more cautious and started bidding fractions of what they thought the drilling rights were worth in order to avoid the curse. If all of the oil companies were bidding .75 what they thought the true value of the drilling rights were worth, they were much less likely to be bitten. A higher-risk operator might be willing to bid .8 the estimated value, whereas a more conservative player might only bid .65. The problem that quickly surfaced is that newcomers to the industry often did not factor in the fractional weighting when making their bids. Well, these newcomers were often bitten by the winner's curse, and while the newcomers might have annoyed the older companies, in the long run it was mainly the newcomers that were hurt.

In baseball more information will also lead to a better bid. A team that understands statistics will probably realize that a certain slugger's gaudy RBI totals are due to his high-OBP table-setters, while a team that doesn't analyze the situation as well will drool over the RBIs and adjust their bid accordingly. A team that understands how aging affects performance is less likely to overbid for the thirty-five-year-old short stop. Caution also comes into play. A GM can estimate a player's value, discount it by a fraction as would an oil executive, and then bid accordingly. The problem is the newcomers. How often do we see a new owner come in and make a big splash in the free agent market? This is the case of the new oil company that hasn't figured out how the modified bidding works to fight against the winner's curse.

Sadly, the baseball owners can't just sit back and watch the new guy squirm under the burden of his foolish purchases. Because of the salary arbitration process the winner's curse becomes everyone's curse. The grossly overpaid shortstop can be used as evidence against all the other teams in baseball when the arbitration process sets the next year's salaries. Perhaps when new owners are initiated into baseball and taught the secret handshake, they also need to be given a short course on the history of oil field economics.