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October 14, 2002
The Winner's Curse
The Winner's Curse
One of the real dangers about presenting any sort of information to any audience for a long period of time is the "context gap". The context gap is what happens when someone presenting material makes bad assumptions about the information that the audience already has. The strangest example of this I've ever seen was at a previous workplace of mine, where a bunch of meeting attendees learned about the details of their severance package before they were notified they were terminated. (Fun with scheduling.) Anyway, on a much less serious note--I received this email from one of the participants at the most recent Concord Pizza Feed:
Good question, and I apologize for using annoying biz-speak.
The Winner's Curse is a term borrowed from the oil industry. It stems from the system of auctions of oil rights to parcels of land. (It may have earlier origins than that, but if so, I'm not aware of them.) Oil companies had to submit bids for the rights to drill for oil in particular parcels of land. The value of those rights is directly driven by the amount of oil on a particular parcel of land. More oil meant more money, which means companies could afford to bid more for the rights to drilling a particular parcel.
But how did companies know how much oil was in a particular parcel?
They took samples. They would tap a test well, and sample how much oil they were able to get. But of course, not all samples were equal. Some samples overestimated how much oil was on the parcel, and some underestimated. Different oil companies had different data on how much oil there was.
Here's an example. This particular parcel of land will actually produce, over time, 45 barrels of oil per day, indicated by the dotted line in the middle of the graph. Each of the four companies bidding on the rights to drill on the parcel have taken samples from the parcel, and have come up with four different estimates of expected production:
Company A (Red Line): 38.5 Barrels/Day
Based on these estimates, the four companies all submit bids to the auction, and Company C bids the most, and wins the rights to drill. Company B had the best information about the actual value of the rights to the parcel, but finished a distant third.
Company C is the winner, but they're also subject to the Winner's Curse. They overestimated the production they would be able to get from the land, and paid more for the rights than they'll make from the 45 barrels of oil per day they'll actually get from the land.
This is obviously a very simplified explanation, but the concept's important.
In baseball, the curse can be considerably rougher on the winner. Not only do organizations have to make assessments about the expected performance of players they sign, they also have to make assessments about the financial gain they can expect to see from that performance. That raises the stakes significantly. If your favorite club predicts that Joe Shlabotnik (2B-R) is going to hit .280/.360/.450 in 600 PA, and he hits .260/.330/.400 instead, they not only missed the forecast for his production, they also probably negatively affected the amount of money they'd make for each unit of his production, be it runs, wins, personality bonus, or whatever. The forces that keep the player from being a good investment for the club pile on to each other, creating a very nasty cycle that clubs can hold clubs back for years, unless they've got extremely talented management.
The Curse sounds nasty, but the reality's probably even worse. In the example of the oil companies, there are some implicit assumptions. Among them is that the oil companies have pretty similar methods of trying to estimate how much oil can be pumped out of a particular parcel. Additionally, the price of oil is pretty much the same for everyone. In baseball, nothing could be further from the truth. Clubs have very different methods of evaluating the expected performance of a ballplayer, and some of them are, frankly, unbelievably bad. They're not even on the right graph. While most teams are calculating runs, maybe a few are using "bat speed." Others do a fantastic job. Those clubs that do a bad job are going to be further away from the "true" production of a player, in both directions away from the truth. That means they're more likely to underestimate or overestimate the value of a particular player, and end up with a spud of a contract. Anyone else remember feeling chills at the Baseball Weekly cover that had Vinny Castilla, Fred McGriff, Greg Vaughn, and Jose Canseco on the cover? And since winning is tied to marginal revenue, the slam that comes down on clubs for these sorts of decisions can be more punishing than watching Estella Warren act.
What can clubs do to avoid being pounded by the Winner's Curse? Do their homework in terms of understanding what drives probable future success. Understand the availability of alternatives or replacements. Accept the fact that sometimes, even good moves don't pan out. Balls bounce funny. Guys get hurt. Players sometimes decline very rapidly for no reason, or bust out because something just clicks. Don't become overdependent on just one or two players.
All you can really do is have a plan, execute it diligently, and stack as many of the percentages in your favor as you can.