The Winner's Curse

Rational Advantages

As commonly understood, economic theory postulates the investor as a rational actor intent on maximizing his or her advantage. This rational actor, it seems, has an instinctive understanding of complex mathematical utility functions that take economists months or years of work to put on paper. Basic economics assumes that individuals seek their selfish best interests and work with unperturbed rationality to identify and pursue those interests, yet this position is very difficult to prove. In fact, many experimental attempts to determine how people really behave call the assumption of rationality into question.

Consider, for example, the well-known case of the prisoner’s dilemma. In this case, two people have committed some crime, and face a choice. If each person refuses to talk, both can expect to receive a one-year sentence. If one person talks, and the other does not talk, the one who talks goes free, while the person who does not talk receives a 10-year sentence. If both people talk, both receive five-year sentences. It does not take a great deal of analytical acumen to see that talking is the best strategy. Yet experiments show that people ...