Ducks and Economics

The Columbia City Council held a special council meeting last night over the proposed deal with IBM which would bring an IBM datacenter + jobs to Columbia. Christine Harbin at the Show-Me Daily has a good cost-benefit analysis on the state and local incentives IBM is receiving to bring their datacenter here; she notes that each job IBM brings to Columbia is subsidized to the tune of about $51,000.

Abby Rogers in the Columbia Missourian today covers last night’s City Council meeting. She notes:

If REDI or other city officials had shared news on the deal with IBM, competing cities might have been able to sweeten their offers and undermine Columbia. In addition, the confidentiality of the proceedings allowed Columbia and IBM to talk business, Brooks said.

It seems obvious to me that letting another city “undermine Columbia” is not necessarily a bad thing. Think of the bidding process as an auction: cities submit “bids” in the form of incentive packages, and the highest bid gets IBM and the datacenter. But consider this: the city with the highest “bid” is also the city that is most likely to have overvalued IBM’s datacenter.

Auction theorists call this the winner’s curse (“you bid, you win, you lose, you curse”). The concept was first introduced by Capen et al in the Journal of Petroleum Technology in 1971 in an analysis of oil and gas leases in the Gulf of Mexico. I was unable to find a copy of the article I could link to but here is are a couple excerpts from their abstract:

If it is true, as common sense tells us, that a lease winner tends to be the bidder who most overestimates reserves potential, it follows that the “successful” bidders may not have been so successful after all. Studies of the industry’s rate of return support that conclusion. By simulating the bidding game we can increase our understanding and thus decrease our chance for investment error.

…

In recent years, several major companies have taken a rather careful look at their records and those of the industry in areas where sealed competitive bidding is the method of acquiring leases. The most notable of these areas, and perhaps the most interesting, is the Gulf of Mexico. Most analysts turn up with the rather shocking result that, while there seems to be a lot of oil and gas in the region, the industry probably is not making as much return on its investment there as it intended. In fact, if one ignores the era before 1950, when land was a good deal cheaper, he finds that the Gulf has paid off at something less than the local credit union. Why? Have we been poor estimators of hydrocarbon potential? Have our original cost estimates been too potential? Have our original cost estimates been too conservative? Have we not predicted allowables well? Was our timing off? Or have we just been unlucky?

Even though Columbia “won” the auction for IBM, we could still “lose” in one of two ways. First, if what Columbia “paid” for IBM to come here is far in excess of what IBM’s datacenter is worth to the local economy. The second way is just a weaker version of the first; we “lose” if the value of IBM’s datacenter is less than what we estimated, even if there is a net gain to be had. This scenario is viable in common value auctions with incomplete information, ie, when lots of cities are bidding for IBM but all of their negotiations are private, which means that the localized information available to policymakers in specific cities is confidential. IBM gets to negotiate from a position of strength and there is no incentive for them to not share confidential information amongst bidders, though individual bidders have incentives to maintain confidentiality. Each individual city thus never gets access to the common pool of information that IBM has, meaning IBM can easily leverage city against city to obtain optimal conditions for itself.

As you might imagine, this isn’t a pleasant thought for anyone who fought to bring IBM to Columbia. Everyone who supports the idea will tell you that their valuation of what IBM is worth to Columbia is excellent and robust. It is not a pleasant thought to think that even rational actors err and err often, and it is counterintuitive that we might benefit from an open and transparent bidding process because it is easy to point to other cities that won a bid and say “we lost”. But it is much harder to win well than we think, and ultimately people are shortsighted.

Suggested further reading on the winner’s curse: Here is Richard Thaler’s excellent 1988 article in the Journal of Economic Perspectives, and here is a good short essay Sfrom Levin and Kagel from Ohio State.