Peter Levin’s Rethinking Markets

September 2, 2008

$10 bill

Filed under: Markets — Peter @ 5:27 pm

When the bidding for the $10 reached $20, I got a little edgy. When it reached $40, I stopped the auction.

Today is the first day of class, and in recent iterations, I have done an exercise where I auction off a real $10 bill. The auction has a lore at Kellogg, and it has been written up in a management education journal. The rules are as follows:

1. Bidding starts at $.50 and proceeds in $.50 increments. And yes, this is for real money.
2. No jump bidding.
3. The auctioneer will give all bidders a fair warning before the auction ends.
4. Cartels and collusion among bidders are strictly prohibited. This means no communication, verbal or nonverbal, is allowed.
5. The highest bidder pays what they bid and receives $10.
6. The second highest bidder pays what they bid.

Yes, I tell them, this is for real money. Instead of a $20 at $1 increments (as in the article), I use a $10 at $.50 increments.

A bit about the composition of my class. There are 25 or so students, in a 9AM class on the first day of the semester. Between 1/3 and 1/2 are Columbia students, and about 1/5 of them are men. These numbers are pretty average for a lecture class at Barnard. These are undergraduates, and although some know each other, they are generally strangers. Before the auction began, I introduced myself, and I had them turn and introduce themselves to their neighbors.

The first auction proceeded, with quite a few bids. As the bids got closer to $10, fewer students bid, and one student who had not bid at all up through $8, $8.50, $9, $9.50 jumped in to bid ‘$10!’. When the next highest bidder bid $10.50, his face kind of fell. The first auction ended up going for $11.50, with the winner paying $11.50 for the $10 bill, and the second highest bidder paying $11.

Then I brought out a second $10. Again, a lively set of bidder engaged with the bidding up to around $8, when a couple of newer bidders joined. This time, they pushed through $10 pretty quickly. A woman in the front row was bidding the ‘evens’ ($10, $11, $12), while a man in the back row was bidding the .50s ($10.50, etc.). When the bidding hit $15, a student next to the back-row man dropped his jaw and started staring at him. At $20, the woman in the front muttered ‘why won’t he stop?’. The class reaction went from laughing (at $10-15), to incredulous (at $20), to a version of what I can only describe as sullen (at $35).

When the auction showed no sign of stopping at $40, like the author of the paper, I stopped the auction, and allowed the students to do a closed-bid, uniform-price auction, or Vickrey auction. The final bids for the $10 were $49, and $51.00. The winner paid $49 for the $10, and the second-highest bidder paid $48.50.

Yes, I took (or am taking, as one of the students asked to pay in installments) the money. I am using it for a charity/class project/treats to be named later. In the article, where the author conducted the experiment at Kellogg management school, with $20 and a group of students both more aggressive and more cash-rich than my undergrads, one auction went up to almost $2000. Yep. $2000.

Why does this work, and what is the value of it for my Sociology of US Economic Life class? It works because the rules of this auction set up conflicting sets of incentives - it facilitates a shift from ‘getting a bargain’ to ‘avoiding a loss’ quickly and easily. The reactions from the students were really interesting as well. One said that at some point, if you’re going to lose a ton of dough, you may as well at least win the $10. Another complained that when the price began to get high enough, the difference between first and second start to get smaller, and it becomes ‘irrational’ for players to keep bidding. I pointed out that it was irrational at $11.

In fact, my point in using the exercise (the management school uses it to demonstrate the challenges of commitment, loss aversion, setting limits and expectations before acting, etc.) is to demonstrate that while markets may work as they are ’supposed to’, the underlying rules matter a huge amount. The devil really is in the details. And just calling something a ‘market’ does not make it efficient, even if it looks generally market-like. This is not inconsistent with some variants of institutional economics of course, and I’m happy to say so - despite some caricatures, not all economic sociologists reflexively bash economists. What I would say, however, is that markets are fundamentally social constructions, and when something is a social construction, you better be clear on the hows before you go ahead and assume it works.

All in all, a pretty intense and hopefully interesting first day of class.

5 Responses to “$10 bill”

1. Jay Livingston Says:
   September 3rd, 2008 at 6:42 am

   I’m curious as to real-life situations that closely resemble this auction. Staying in this auction is not like holding on to some losing investment in the hope that it will turn around. All participants know that once they pass the $10 mark, they’ll wind up in the red; they also know that the longer the auction goes on, the greater the losses will be.

2. Peter Says:
   September 3rd, 2008 at 8:18 am

   Interestingly, the author of the article (Keith Murnighan) notes a couple of analogs with regard to acquisitions:

   Corporate acquisitions provide many pertinent examples. The process behind Viacom’s purchase of Paramount Communications, for instance, is well documented. In the summer of 1993, Viacom made an offer for Paramount that was valued at $63 per share (with various contingencies). At about that time, Paramount’s stock had been selling for $52 a share. In mid-September Viacom increased their offer to $69. On September 20, QVC entered the scene with a hostile bid. This set off a bidding war between Viacom and QVC. By late October, both QVC and Viacom were bidding $80 per share. (Their own stocks, at the time, were valued at $56 and $60, respectively.) Bids went back and forth, increasing from $85 to $92 to $105. Finally, in February of 1994, Viacom made its final, successful bid, valued at $107 per share. By then, both Viacom’s and QVC’s own stock had fallen, to $39 for Viacom and $45 for QVC. Both bidders were hurt by their bidding war, but Paramount’s shareholders did extremely well. The acquisition premium, the increase from the price prior to takeover news to the ultimate price paid, was 110% (Hayward & Hambrick, 1997). This acquisition process, which resulted in a tremendously risky strategy, looks much like the process in the Dollar Auction, but for much higher stakes.
   (p. 65)

   I think the main catch is that commitment is a really challenging thing to get away from. It certainly makes me appreciate the importance for my art specialists of ‘getting the right asses in the seats’ for a particular auction.

3. Jay Livingston Says:
   September 3rd, 2008 at 9:33 am

   1. Are there real markets, or any real-life situation, that closely resemble this kind of auction? In some loss-avoiding scenarios, the person throwing good money after bad has at least some hope — a seventh card that fills a straight, a lucky break that turns a stock around. But in this auction, everyone knows that as soon as the bid goes over $10, any bidder is a loser, and that the losses can go only higher. The only hope is that the other bidder will fold.

   2. What effect does this classroom exercise have on the way students feel about the class or the instructor in the short and long run? I’d be afraid to try it for fear the students would wind up hating me for putting them into this no-win situation. They’d come away thinking that the devil was not in the details but standing in front of the class.

4. Peter Says:
   September 3rd, 2008 at 9:37 am

   Well, that second question remains to be seen, though my initial sense is that it was an effective demonstration. It was the first time it ever got to be so high, so I don’t really know. I certainly could have screwed myself over with the exercise in terms of building a community of trust.

   I’d say again for the first question that commitment is a big deal. I seem to recall some experiment in my undergraduate social psych class about sunk costs - you have already spent $10 million on an experimental, uncompleted jet, and expect to spend another $7 to make it complete. And then you learn that there is a $5 million alternative that would be complete at the same time and be better. Would you scrap the first project or build it to completion. Some really high percentage go for the first project even though it can not possibly be a useful thing to do given the assumptions.

   I think especially with regard to markets we economic sociologists have gotten ourselves into a weird dynamic with economics about ‘rationality’ and the fabled twenty-dollar bill.

5. Fringe Thoughts - Never buy on ebay Says:
   September 12th, 2008 at 12:01 pm

   [...] of this is a round about way of passing on this lovely blog post about the irrationalities of auctions from the interesting blog http://www.rethinkingmarkets.org/ (I’ve added them to our blog [...]

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