Key Takeaways
- The dollar auction is a game designed to highlight irrational decision-making.
- It shows how rational strategies can lead to unexpected losses.
- Bidders often end up paying more than a dollar for a dollar.
- The auction demonstrates the “escalation of commitment” in competitive settings.
- Martin Shubik used this game to explain noncooperative behavior in economics
What Is a Dollar Auction?
Economist Martin Shubik created the dollar auction to show how rational choice can lead to irrational outcomes. In this setup, players often bid more than a dollar for a one-dollar bill as their goal shifts from making a gain to avoiding a loss. Like the prisoner’s dilemma, the game reveals how individually rational decisions can escalate into collectively unfavorable results.
How Dollar Auctions Illustrate Rational Behavior
A dollar action is a simple game, where two participants bid on a dollar bill. The highest bidder receives the bill. However, the loser must pay the amount that they offered as well. When bidding in the game begins to approach or go beyond $1, the players’ game goals change. Instead of maximizing their potential gain, players now try to minimize their potential loss.
A dollar auction starts with an auctioneer accepting the initial bids of two participants. After that, it does not make sense for them to stop bidding up the price. For example, if an auction leads to Participant A bidding 90 cents, followed by a $1 bid from Participant B, Participant A can either offer $1.01 and lose 1 cent or drop out of the auction and lose 90 cents.
Bidding more than a dollar for a dollar is not logical. At the same time, losing 90 cents is not as smart as losing 1 cent. In this game, the rational move would be to place the bid which leaves Participant B in a similar situation. In other words, either bid $1.02 and lose 2 cents or drop out and lose the dollar. In theory, the bidding process could continue in perpetuity as long as both players remain committed to winning the dollar.
Exploring Game Theory Through the Dollar Auction
The dollar auction shows how rational behavior can lead to an undesirable outcome. In that sense, it is similar to the more widely known prisoner’s dilemma, which stipulates that rational individuals might not cooperate with each other, even when it appears that it would be in their best interest to do so.
American economist Martin Shubik invented the dollar auction to reveal the consequences of what he called the “escalation of commitment.” Shubik, a pioneer in game theory, posited that the dollar auction shows how people can become obsessed with the idea of losing, even though they know that they can still lose by winning.
In his 1971 article, “The Dollar Auction Game: A Paradox in Noncooperative Behavior and Escalation,” Shubik indicated that he particularly enjoyed seeing the game’s dynamics play out in party settings and in front of a large crowd. “Once two bids have been obtained from the crowd, the paradox of escalation is real. This simple game is a paradigm for escalation. Once joining the contest, the odds are that the end will be a disaster to both.”
The Bottom Line
The dollar auction shows how rational choice can spiral into irrational outcomes, with players bidding past a dollar’s value because both the highest and second-highest bidders must pay.
This structure encourages escalation of commitment, a dynamic familiar in game theory. Like the prisoner’s dilemma, it demonstrates how individually rational decisions can still produce poor collective results.
