Hypothetical Bias in Private Value Auctions with Costly Information Acquisition*

A number of recent papers in environmental economics have focused on the process of researching preferences – agents are uncertain about preferences but at a cost may narrow their uncertainty. This issue has arisen in formulating bids in contingent valuation as well as the debate over the divergence between WTP and WTA. In the context of contingent valuation, it has been hypothesized that the hypothetical nature of the preference elicitation biases responses. This paper provides both a theoretical model and experimental evidence to contribute to this debate. The model consists of a series of auctions where subjects compete for an object with private but unknown value – the Risk Neutral Rational Expectations model. The information regarding the value of the object is costly. Furthermore, at the end of the auction, a random number is drawn to determine if the whole process is hypothetical or not. The experiment tests this theoretical model of bidding equilibrium and analyzes the effects of variations in the parameters (hypotheticalness, information costs and number of agents) on the endogenous variables (such as the proportion of bidders who buy information and the winning bid). Experimental results are generally consistent with the theoretical model. In particular, an increase in the hypotheticalness of an auction tends to decrease the size of the winning bid and decrease the extent to which bidders pay for information on their valuation.