Latest / Behavioral Economics with Fexingo: Decision Making, Bias, and How People Really Spend / How a One-Dollar Auction Traps Rational People
Transcript
- Lucas: I was at a conference a few years back. Two software engineers got into a bidding war over a twenty-dollar bill that someone had taped to the wall. By the end, they had collectively bid forty-two dollars. The winner paid twenty-three. The loser paid nineteen — for nothing. Luna: Wait — they both walked away poorer than if they'd just torn the bill in half and shared it? Lucas: Exactly. And this wasn't an anomaly. It's a classic demonstration of something called the dollar auction, first described by the economist Martin Shubik back in 1971. Luna: I've heard of this. The setup is deceptively simple: the auctioneer puts a one-dollar bill up for bidding. Bids start at a nickel. But there's a twist. Lucas: Right. The twist is that both the winner and the second-highest bidder have to pay their bids. Only the winner gets the dollar. So if you're the second-highest bidder at, say, fifty cents, you lose that fifty cents and get nothing. The only way to avoid that loss is to raise your bid to sixty cents — and now you're the leader. But then the other person faces the same choice. Luna: So the trap is that once you're in, the rational move is to keep bidding, even past the point where the dollar is worth less than what you're paying. Lucas: That's the mechanism. In Shubik's original paper, he ran the auction in classrooms and found that the final price frequently exceeded a dollar. Sometimes two dollars, three dollars. In one notorious example, two students at a seminar bid the price up to twenty-six dollars for a single dollar bill. Luna: And this isn't just a classroom stunt. You see this pattern everywhere. Corporate bidding wars where companies overpay for a target because they've already spent millions on due diligence and advisory fees. Lucas: Exactly. There's a well-documented case from the early 2000s where two telecom companies bid against each other for a wireless spectrum license. The final price was something like ten times the initial estimate. Both companies had already invested so much in the process that walking away felt like accepting a huge loss. Luna: The sunk cost fallacy in full display. You've already spent the money, so you tell yourself you have to see it through. But the only thing that should matter is the future costs and future benefits. Lucas: And that's what makes the dollar auction so insidious. Even when you know the trap intellectually, it's hard to escape in the moment. The bids are small at first — a nickel, a dime. It doesn't feel like a big deal. By the time you realize you're over your head, your brain is already framing the next bid as the lesser of two evils. Luna: Loss aversion plays a huge role here. Losing twenty cents feels worse than gaining a dollar feels good. So you escalate to avoid a small loss, and that small loss becomes a bigger one. Lucas: Shubik himself noted that the dollar auction is a trap for rational players. Each individual decision to raise the bid by a nickel makes sense if you ignore the history. But the history is what matters. And the structure of the game ensures that the history keeps piling up. Luna: So how do you avoid it? Say you're in a negotiation or a bidding situation. What's the escape hatch? Lucas: The best strategy is to set a maximum bid before the auction starts — and stick to it. Decide in advance what the prize is worth to you, and don't let the heat of the moment change that number. Luna: But that's easier said than done when you're in the middle of it. The other person is bidding, the crowd is watching, your ego is on the line. Lucas: Right. That's why some people use a version of the 'Ulysses pact.' Ulysses had his crew tie him to the mast so he couldn't succumb to the sirens' song. You can pre-commit by giving your bidding authority to someone else who's not emotionally involved. Or you can announce your maximum publicly — that way, backing down after that point is a commitment, not a defeat. Luna: There's a famous story about Warren Buffett. He's said that when he goes into an acquisition, he has a 'walk-away price' written on a piece of paper. He doesn't let his advisors or the seller know what it is. He just sticks to it. Lucas: That's a perfect example. And it works because it removes the escalation dynamic. The other side can keep raising the price, but once they cross your line, you're done. You don't feel the need to justify a higher bid because you've already decided. Luna: I think the dollar auction also applies to personal decisions. Like when you're renovating a house and the contractor finds a problem that adds ten thousand dollars. You've already spent thirty, so you feel like you have to spend the ten. But at some point, it's cheaper to sell the house as-is and buy a different one. Lucas: That's exactly the same structure. The prior spending is irrelevant. The question is: given where you are now, what's the best path forward? The dollar auction shows us that we systematically fail to ask that question because we're wired to avoid realizing losses. Luna: One more thing that's interesting: Shubik's auction has a flaw if you think about it as a pure game theory problem. If both players could cooperate, they'd agree to split the dollar and both walk away with fifty cents. But the auction is designed to prevent cooperation — you can't communicate, and there's no binding contract. Lucas: That's a key insight. In many real-world situations, communication is possible. If you and your competitor are both about to bid on the same asset, you might be able to signal that you'll both walk away if the price gets too high. But that's collusion, and it's often illegal in formal auctions. Luna: So the dollar auction is really a cautionary tale about the structure of the game itself. If you design a game that rewards escalation, you'll get escalation — even from smart, rational people. Lucas: And that's why understanding it matters. Because these games are everywhere. The next time you find yourself bidding against someone — or even just arguing about who should pay for dinner — ask yourself: am I in a dollar auction? And if I am, what's my walk-away number? Luna: You know, this is exactly the kind of thing that makes me glad we do this show ad-free. We don't have to sell you anything. We just get to talk about ideas that actually help you think. Lucas: Absolutely. If walking through the economy with us has made something click, and you want to support that choice, the link is buy me a coffee dot com slash fexingo. No pressure, no perks — just a way to keep the conversation going without any commercial breaks. Luna: Yeah. And it means we can spend the whole episode on something like the dollar auction instead of cutting away to sell you mattress toppers. Lucas: Right. So back to that conference I mentioned at the start — the two engineers who bid forty-two dollars on a twenty. After the auction, the winner came up to me and said, 'I know I overpaid, but at least I beat that other guy.' And that's the real lesson. The dollar auction doesn't just trap your wallet. It traps your identity. Luna: You're willing to lose money to avoid losing face. Lucas: Exactly. And once you recognize that, you can start to separate your ego from your bank account. That separation is the only way to win a game you can't actually win.