Level-k Auctions: Can a Non-Equilibrium Model of Strategic Thinking Explain the Winner's Curse and Overbidding in Private-Value Auctions?

This paper proposes a structural non-equilibrium model of initial responses to incompleteinformation games based on "level-k" thinking, which describes behavior in many experiments with complete-information games. We derive the model's implications in firstand second-price auctions with general information structures, compare them to equilibrium and Eyster and Rabin's (2005) "cursed equilibrium," and evaluate the model's potential to explain behavior in auction experiments. The level-k model generalizes many insights from equilibrium auction theory. It also allows a unified explanation of the winner’s curse in common-value auctions and overbidding in those independent-private-value auctions without the uniform value distributions used in most experiments. Level-k Auctions: Can a Non-Equilibrium Model of Strategic Thinking Explain the Winner's Curse and Overbidding in Private-Value Auctions? Vincent P. Crawford and Nagore Iriberri University of California, San Diego 15 October 2005; revised 4 November 2005 "The common curse of mankind, folly and ignorance, be thine in great revenue!" —William Shakespeare, Troilus and Cressida Abstract: This paper proposes a structural non-equilibrium model of initial responses to incomplete-information games based on "level-k" thinking, which describes behavior in many experiments with complete-information games. We derive the model's implications in firstand second-price auctions with general information structures, compare them to equilibrium and Eyster and Rabin's (2005) "cursed equilibrium," and evaluate the model's potential to explain behavior in auction experiments. The level-k model generalizes many insights from equilibrium auction theory. It also allows a unified explanation of the winner’s curse in common-value auctions and overbidding in those independent-private-value auctions without the uniform value distributions used in most experiments. This paper proposes a structural non-equilibrium model of initial responses to incomplete-information games based on "level-k" thinking, which describes behavior in many experiments with complete-information games. We derive the model's implications in firstand second-price auctions with general information structures, compare them to equilibrium and Eyster and Rabin's (2005) "cursed equilibrium," and evaluate the model's potential to explain behavior in auction experiments. The level-k model generalizes many insights from equilibrium auction theory. It also allows a unified explanation of the winner’s curse in common-value auctions and overbidding in those independent-private-value auctions without the uniform value distributions used in most experiments.