Responsibility for Cost Management Hinders Learning to Avoid the Winner’s Curse

1. Responsibility for Cost Management Hinders Learning to Avoid the Winner’s Curse By: Bloomfield and Luft Presenter: Sara Aliabadi October,9, 2008

2. Question Can feedback from repeated competitive bidding markets teach people to bid well above estimated costs to avoid the winner’s curse?

3. The Winner’s Curse • What is winner curse? • Cooper 1989; Cooper et al. 1992; Turney and Ittner 1993; Hilton 2005 • Define Winner’s curse: • Firms win market share but lose money on products or services that are priced too low because their cost is underestimated.

4. Why Winner’s Curse happen? • Winner curse happens because sellers fail to recognize that bidder with lowest costs estimate is likely to have the largest cost underestimate. • This is because cost is underestimated and bidder has to bid even lower than the cost to win. • Equilibrium strategy is to pad bids enough to make a satisfactory expected profit conditional on winning the bid. • Prior studies show that sellers fail to pad bids enough to eliminate the winner’s curse completely.

5. Hypothesis Development • The optimal amount of padding depends on sellers’ beliefs about their competitive position. • Managers can sometimes use feedback to identify and adjust for the winner’s curse. • The winner’s cruse has been shown to persist with professional bidders.

6. Hypothesis Development • Attribution Biases • Research in psychology has extensively documented self-serving attribution bias, i.e., individuals’ tendency to take credit for success and attribute failure to factors out of their control. • Sellers with responsibility for cost management will be less willing to attribute losses to high actual costs.

7. Hypothesis • We predict that sellers with responsibility for both bidding and cost management will learn to increase padding more slowly than those who have responsibility only for bidding. H: Compared to sellers who are responsible for only pricing decisions, sellers who are responsible for both pricing and cost-management decision learn less well from market feedback to avoid the winner’s curse.

8. Overview and Experimental Design • WE have 64 M.B.A. students. • Students participated as sellers in auctions for production jobs. • Participants are randomly assigned to a “responsibility” setting choose their own cost-management initiatives based on information about the initiatives’ past performance. • Sellers received an estimate of their product cost.

9. Overview and Experimental Design • Sellers bid on contracts for large complex projects, • Estimated project costs includes error, • Seller’s firms undertake cost-management initiatives that are intended to increase their cost advantage.

10. Prior studies VS this study • In this study we do not inform participants of the parameters of the setting; rather, sellers must learn parameters of setting from experience. • They should attribute past bids and earnings outcomes to either noise in cost estimates or variation in competitive advantages. • prior studies had participants bid on asset with a common cost or value. • Winning the auction provides a strong signal that one’s estimate of cost or value is too optimistic.

11. Bidding and Feedback • In each period, participants learned their own estimated costs and entered bids. • After each round of trading, participants learned whether they personally entered the winning bid, and the earnings of the winning bidder. • We provide extremely informative feedback to maximize the extent of learning over the course of the session.

12. Results • To test our hypothesis: • We examine the extent to which sellers “pad” their bids by bidding above the estimated cost provided by their cost accounting system. • (Pad = bid – estimated cost) • We test the seller’s mean padding over different periods. • Figure 3 and Table 1show evidence that sellers learn to increase their padding and do so more effectively in the no-responsibility setting.

13. Analysis of Learning from Feedback • How responsibility for cost management affects sellers’ period-by-period learning from feedback? • We use the following regression: PadChange = F(Cohortprofit, WinDum, Cohorprofit*WinDum) • Where : • PadChange = change in padding of bidder i from period t-1 • CohortProfit = profit of low bidder in cohort in period t-1 • WinDum = a dummy varialbe

14. Result of Regression • Table 2: responsibility and no-responsibility sellers react differently to the magnitude of prior-period losses. • In both conditions, the more money a bidder loses in period t-1, the more other sellers increase their padding in period t. • Seller who feel responsibility for their competitive advantage will have difficulty learning from feedback.

15. Discussion • Prior research show that individual can learn from feedback to adjust for error in cost estimation. • Individual in prior studies made decision relating price only. • We compare performance of individuals with responsibility for pricing decision and for cost-management decision.

16. Discussion Continued • Market feedback eliminates the curse of sellers who make only pricing decisions. • Sellers with cost-management responsibility spend longer on the pricing but are not successful in improving their pricing decision. • The effect we observe are related to escalation bias. • We show that accounting-related decision errors will not be eliminated through market discipline.