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It was the fall semester of 2009, and I was teaching an Industry and Competitor Analysis course to a group of part-time MBA students at the Robert H. Smith School of Business, University of Maryland, College Park. One of the topics included in the course syllabus was Game Theory, always a fun subject to teach. On the day the topic was to be covered, I asked my students if they wanted to play a game with me and, naturally, excited at the prospect, they said yes.
I took a $100 bill from my wallet and told the students the note was up for a live auction. All the students were eligible to bid. Bidding was to start at $5, could then proceed with $5 increments, and the students could not coordinate their bidding strategy with each other. The highest bid would get the $100 bill for the amount of the final bid. The only other rule was that the second highest bidder would have to forfeit the amount he had bid and give me the money. The class had 21 students, most of whom were in their thirties and had good jobs.
“Is this for real?” one student asked me. I said yes, and the bidding started. $5, $10, $15, and so on. Several students participated in the bidding until the amount they bid reached about $75. At that stage, most of the bidders had dropped out, and only two students remained active in the bidding process. Bidding continued, $75, $80, $85, and so on, until a bid amount of $135 was reached. There was a sense of excitement in the class, but also nervousness to see where the bidding might end. At that time, the highest bidder said to the second highest bidder, “I will bid $5 more than whatever you bid.” Hearing this, the second highest bidder stopped bidding and the auction ended.
I offered my $100 bill to the highest bidder, and said, “You owe me $135.” To the second highest bidder, I said, “You owe me $130.” They were both speechless and the class was stunned, dumbfounded that their professor could play such a trick on them.
After several minutes of nervous confusion in class, I said to the highest bidder, “I had saved this $100 to buy pizza for the class on the last day of the course. You take it and buy pizza for the class. If you spend more than $100, you pay for it yourself; if you spend less, you can keep the remaining amount.” The class heaved a sigh of relief!
How had this strange scenario developed, in which two bidders offered significantly more for an item than it was worth. The answer lies in studies by scholars Daniel Kahneman and Amos Tversky, which showed that the perception of loss is psychologically 50 percent more powerful than the perception of gain. This is known as loss aversion in behavioral economics. If an individual is presented with two equally likely choices—one presented as a potential gain and the other as a possible loss—the latter choice tends to be selected. Kahneman and Tversky suggested that the aggravation one experiences in losing a sum of money is stronger than the pleasure associated with gaining the same amount. (Psychologist Kahneman received the Nobel Prize in Economic Sciences in 2002 for his groundbreaking work on decision making under uncertainty. Tversky died in 1996 and was acknowledged in the Nobel Prize announcement; the Royal Swedish Academy of Sciences does not award prizes posthumously.).
This theory was underscored by my small experiment in class. For the bidding students, avoiding a big loss outweighed the potential of winning $100, so the two remaining bidders kept bidding. When someone becomes committed to a strategy of avoiding loss rather than winning, he/she will try not to lose.
Professor Max Bazerman, of the Harvard Business School, used to start the first day of his MBA class with this game and never lost money; he donated his winnings to charity. Once he played the game with a group of Wall Street professionals, and the highest bid reached $465!
Questions for the reader: Did you, in your personal life, ever experience such a dilemma? If you had never heard about the game, how much would you be willing to bid if you were one of the last remaining bidders in the auction?