50. Expectations-Based Loss Aversion in Common-Value Auctions: Extensive vs. Intensive Risk
Date of publication: October 2018
Working paper number: 50
Abstract: We analyze the behavior of expectations-based loss-averse bidders in frist-price and second-price common-value auctions. Highlighting the distinction between the uncertainty bidders face over whether they win the auction (extensive risk) and that over the value of the prize conditional on winning (intensive risk), we show that loss-averse bidders react differently to these different kinds of risk. In particular, the intensive risk pushes bidders to behave less aggressively in a common-value environment compared to one with private values. Yet, despite this "precautionary biddinging" effect, in equilibrium bidders can be exposed to the "winner's curse". We consider two alternative specifcations for how bidders assess outcomes as either gains or losses. Under narrow bracketing, bidders experience gains and losses separately over whether they receive the prize and how much they pay. Under broad bracketing, instead, bidders assess gains and losses over their net surplus. With narrow bracketing, first-price auctions expose bidders to less intensive risk and yield a higher expected revenue than second-price auctions, while the opposite result might hold with broad bracketing.