Free agents, the draft, and the winner's curse

The NBA season is just six weeks away, and the NFL starts this Thursday (or Friday for those of us in New Zealand). So, thinking about this recent article by Ben Falk is timely, and gives an excellent explanation of the winner's curse:

Three real estate investors are bidding on a building of unclear value. The first doesn’t think it’s a great property and enters a low bid. The second decides it has a lot of untapped potential and enters a very high bid. The third can see both pros and cons and offers something in between. The winner, of course, will be the second investor, the one who values it the most.

But here’s the problem: that investor is also the most likely to have overvalued the property. If this second investor is wrong about their guess that the building has untapped potential they’ll be stuck paying too much. This is a phenomenon known as the Winner’s Curse, where the winner of the bid will be the most likely to have priced it incorrectly. It applies to many types of bidding situations, and NBA free agency is no exception.

The team paying the most for a free agent is the team who values that free agent the most — who likely overvalues the player the most. It’s possible that all of the other teams with money undervalue the player and so the winner gets good value. But more likely than not the winning bidder will be the one that overpays the most.

The winner's curse doesn't just apply to free agents, but also to the draft. Teams don't have perfect information about each player available in the draft. Some teams will over-estimate the value of a player (and want to draft that player earlier), and other teams will under-estimate the value of a player (and want to draft that player later). Holding other things constant (like each team's needs for players in particular positions), the team that holds the most positive views of a player (that is, the team that most over-estimates their value) will draft that player. This suggests that many players are drafted too high - the winner's curse. As evidence of this, the NFL in particular has a long list of high draft picks who turned out to be busts (try this list, or this one).

Falk's article is also interesting in that it talks about endowment effects. Quasi-rational decision makers are loss averse - we value losses much more than otherwise-equivalent gains. That makes us are unwilling to give up something that we already have, or in other words we require more in compensation to give it up than what we would have been willing to pay to obtain it in the first place. Falk notes that:

Some overpay to keep their own free agents, falling victim to the endowment effect and thinking more highly of something they already have.

I'm less sold that endowment effects are an issue in pro sports. An endowment effect would require the teams to be trading players. With free agency that doesn't happen - they deal direct with the players. However, where teams do trade players (in exchange for draft picks or other players), they may hold out for more than the player is actually worth. Which probably reinforces the winner's curse for the team that receives the traded player.

[HT: Marginal Revolution, back in July]