# Introduction

Anytime you have an auction, you have the potential for the
winner’s curse,
a simple, yet surprising, statistical phenomenon. Despite its
simplicity, the effect can have significant financial implications
for anyone participating in auctions.

We care about the winner’s curse at NextRoll because we
post, we explain the curse and explore the way it manifests

# Understanding the Curse

Let’s pretend Alice is auctioning off a jar containing exactly
\$25 of spare change she has collected. N of Alice’s friends
participate in the auction, hoping to purchase Alice’s jar of
change. No one can open the jar before the auction, but each of
Alice’s friends can inspect the jar to estimate the total worth
of the coins contained within. After completing their valuations,
each of Alice’s friends submit a bid.

Alice’s friends assume one of them can make a few dollars here.
However, it may be the case that one of them overestimates the
value of the coins in the jar. As a result, that person may bid
too much into Alice’s auction. If this happens, that person may,
depending on the auction dynamics and the other bids, end up
paying Alice more for the jar than the value of the coins
contained within.

It turns out that the winner of Alice’s auction will end up
overpaying for the jar of change much more frequently than we
would naively expect; this is the winner’s curse. To see how
this works, let’s denote Alice’s ith friend’s valuation as
follows:

%<![CDATA[
begin{equation}
V_i = 25 + epsilon_i
end{equation}
%]]>

where epsilon_i is the error each friend makes in their
valuation. The highest valuation of the jar of coins among
Alice’s N friends will be:

%<![CDATA[
begin{equation}
max(V_1, … ,V_N) = 25 + max(epsilon_1, … , epsilon_N)
end{equation}
%]]>

This highest valuation is very likely to be larger than \$25. To
see why, let’s assume Alice’s friends are equally likely to
overestimate the value of the coins as they are to underestimate
it. In this case, for the highest valuation to be less than \$25,
all N of Alice’s friend’s bids have to underestimate the value
of the jar of coins. This happens only frac{1}{2^N} of the
time.

This discussion of the highest valuation is important because,
typically, the person with the highest valuation will win the
auction. Let’s call this person with the highest valuation, whom
we expect to win the auction, Bob. If Bob wins the jar of change
and tallies up the money, he is probably in for a nasty surprise.
Almost every time, the jar will have less money than he anticipated
it having. Many times, this effect is so pronounced that not only
will Bob have not made as much profit as he had anticipated, he
will have lost money! Just like that, Bob has fallen victim to
the curse!

## Simulating the Curse

To further illustrate this effect, we can make some concrete
assumptions and run a simulation. Let’s pretend the error each
of Alice’s friends make when estimating the jar of coins’ value
is distributed normally with a mean of \$0 and a standard
deviation of \$3. That is, epsilon_i sim mathcal{N}(0, 3^2).
Let’s pretend Alice is running a second-price auction, in which
the bidders naively assume bidding their noisy valuation is
optimal. Below we see what happens with 4, 7, and 10 of Alice’s
friends bidding into her auction.

In this simulation, Bob usually paid more for the jar of coins
than it is worth. This happened almost every time with just ten
of Alice’s friends participating in the auction. Also notice,
the more participants the auction has, the worse the winner’s
curse becomes.

This shows that when you’ve estimated the value of an item in an
auction, you should reduce your bid, not just to account for
auction dynamics, but also to account for uncertainty in your
valuation. In particular, despite conventional wisdom saying to
bid your true valuation in a second-price auction, you should
actually reduce your bid a bit in most real-world situations.

# Observing of the Curse

Now that we understand the winner’s curse, we can see what it
looks like in some real data. There are two places we observe
the winner’s curse at NextRoll. When an ad exchange notifies
us of an ad opportunity, we have to select an ad for which to
bid. This is done via an internal auction and is the first place
this effect manifests. Next, we submit the highest internal bid
to the ad exchange, and an auction is run amongst bidders like
NextRoll. This external auction is the second place we observe
the winner’s curse.

To be clear, I highlight these instances of the winner’s curse
because the effect is interesting, not because these cases are
particularly problematic. Unlike in the example of Bob losing
money by purchasing Alice’s jar of coins, the impact of the
winner’s curse on NextRoll’s bidding systems is minor overall.

## The Internal Auction

The internal auction is where we decide which ad from our
thousands of advertisers will be submitted to the external
auction. Some of this decision is made for us by simply applying
the advertiser’s targeting criteria. Selecting among the remaining
advertisers’ eligible ads is done with an auction that has two steps.

As you can see below, the more ads from which we have to select for
a given advertiser, the more overvalued the selected ad is. This is
analogous to the winner of Alice’s auction paying more for the jar
of coins when there are more bidders. This is the winner’s curse in
action!

The second step in the internal auction is to choose the most
case above, the more advertisers targeting the opportunity, the
more overvalued the selected ad is. Again, this is the winner’s
curse.

## The External Auction

Once we have decided which ad to select and what to bid for it, we
send that information to the ad exchange. The exchange runs another
auction, and based on the results, makes the final decision on which
ad to show. Unlike in our internal auction, we are not the
auctioneer in the external auction, which means we don’t have
complete information about the auction’s bids. This makes confidently
observing the winner’s curse more challenging.

The first sign of the winner’s curse in the external auction is that
we consistently predict ad impressions to be slightly more valuable
than they turn out to be. To have confidence that these
overvaluations really are the winner’s curse, rather than an
undiscovered bug, we will need to understand a bit about the
interaction between our machine learning and the external auction.

The key thing to understand is that the valuations predicted by our
machine learning system are very closely related to when we win the
external auction. In particular, when our models overvalue a
potential impression, we tend to bid higher, which causes us to win
the auction more often. In other words, we win a disproportionate
amount of the bids whose value we overestimate. This selection bias
is visualized below.

Fortunately, when we win the external auction and show an ad, we
into our machine learning models as training data. As a result,
mistakes made by previous iterations of the model are corrected.
Unfortunately, no model is perfect, and our newer model iteration
will make new mistakes.

The crucial insight for our investigation is that by comparing the
over the same slice of backtesting data, we can learn whether the
overvaluations we observe are, in fact, caused by the winner’s
curse, or more menacingly, an undiscovered bug.

To make this concrete, let’s say that we trained model A ten days
ago, and that we trained model B yesterday. Consider what we would
expect to happen if we used both models A and B to predict over
yesterday’s ad impression data that model B bid on and purchased.
If the winner’s curse were the cause of the overvaluations in the
external auction, we’d expect model B to overvalue these impressions
that it purchased because of the selection bias discussed above.
We’d also expect model A to value these impressions accurately.
This is because this selection bias affecting model B does not
apply to model A, since it was not used to bid on and purchase
these impressions.

The plot above shows this experiment run over real data on 11
different days. As you can see, model A does not overvalue the ad
impressions purchased by model B. This means we really are
observing the winner’s curse in the external auction!

# Conclusion

You’re more likely to win an auction when you bid too high. That is
the essence of the winner’s curse, a surprisingly simple, yet
counter-intuitive, statistical effect. In this post, we learned how
the curse works in theory, and we observed it in some real data.

Often, those of us interested in auctions ignore the fact that
bidders estimate the value of an item, assuming instead that they
know it exactly. However, bidders having uncertain valuations is all
that’s needed for the winner’s curse to appear. When the curse strikes,
buyers realize less profit than expected from the auctions in which
they participate. In extreme cases, this effect can even result in
the buyer losing money, as we saw with Bob and Alice. Beware of the
curse!

Source: New Tech

Categories: Marketing