Suppose you have four oil companies all interested in the same patch of offshore property. Back in the 1950s the methods available for determining the amount of liquid gold under a few hundred feet of water were primitive. This led to a large spread in the estimations of the value of the oil, and hence the drilling rights. Suppose that after all the costs of drilling were accounted for there was $10M worth of oil in the ground. Company A might determine that there was only $5M worth of oil. On the other hand, Company B might nail it at $10M, Company C could value the oil at $12M and Company D could make a gross overestimation and believe that there was $20M worth of oil in the ground.
Now we come to the bidding for the drilling rights. At $5M, Company A drops out of the competition. At $10M, we lose Company B. At $12M Company C bows out, and Company D is very happy because they have paid $12M for property they believe is worth $20M. But since there is only $10M worth of oil in the ground, Company D is in the red for $2M. They have suffered the winner's curse. In an auction, the prize goes to whoever has the most optimistic view of the value of the object being bid upon. In many cases, this also means that the winner is the person who has overestimated the most.
Be Sure to Continue to Page 3 of "The Winner's Curse - Oil Field Economics and Baseball".
