Explaining Overbidding in First Price Auctions Using Controlled Lotteries

In this paper, we study the behavior of individuals when facing two different, but incentive-wise identical, institutions. We pair the first price auction with an equivalent lottery. Once a subject is assigned a value for the auctioned object, the first price auction can be modeled as a lottery in which the individual faces a given probability of winning a certain payoff. This set up allows us to explore to what extent the misperception of the probability of winning in the auction is responsible for bidders in a first price auction to bidding above the risk neutral Nash equilibrium prediction. The first result we obtain is that individuals, even though facing the same choice over probability/payoff pairs, behave differently depending on the type of choice they are called to make. When facing an auction, subjects with high values tend to bid significantly above the bid they choose in the corresponding lottery environment. We further find that in both the lottery and the auction environments, subjects tend to bid in excess of the bid predicted by the risk neutral model, at least for intermediate range values. Finally, we find that the difference between the lottery behavior and the auction behavior is substantially, but not totally, eliminated by showing the subjects the probability of winning the auction. Copyright Kluwer Academic Publishers 2003