A Note on Bidding Strategies

c Øyvind Norli

Contents
1 Introduction 1

2 Private value 1
2.1 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2.2 Optimal bidding in a private value auction . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2.3 Optimal bid with toehold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

3 Common value 4
3.1 Optimal bidding in a common value auction . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3.2 Optimal bid with small strategic advantages8 . . . . . . . . . . . . . . . . . . . . . . . . . 5

A Private value no toehold 7

1 Introduction
During the first class of Applied Valuation you will be introduced to auctions. The main purpose of is to
develop an understanding of the “Winner’s Curse”.
We will explore bidding strategies in auctions through various “in class” auctions. To prepare for
class you only need to familiarize your self with the following terms: Private value auction, common
value auction, Winners Curse, and toehold. Before class, you do not need to worry too much about the
optimal bidding strategies described in this note.

2 Private value
In a private value auction, each bidder has a private value for the item being sold in the auction. For
example, if you are bidding for a bottle of vintage wine that you plan to consume yourself (say a 1959
Chateau Mouton Rothschild because you feel rather like James Bond), you will have a private value for
the object up for sale. Your value will typically be different from the value put on the object by other
bidders. In a takeover context, bidders could have private values for the target if they have vastly different
plans and abilities to utilize the target’s assets. In other words, the synergies between the bidders and
the target are unique to each bidder. When modeling a private value auction, it is typically assumed
that each bidder knows his own private value, but only have an uncertain estimate of the private value
of competing bidders.

2.1 Model
Assume that there are two corporate bidders for a target. We refer to the bidders as bidder 1 and bidder
2. They have private values v1 and v2 for the target. To simplify the analysis, assume that v1 and v2 are
independently uniformly distributed on the interval [0, 1].1 Table 1 shows some useful properties for this
1 This means that the value v can take on values between 0 and 1, that any value is equally likely, and that the realized
1
value of v1 is not related to the value of v2 .
Bidding strategies 2

distribution.

Table 1 Properties of the [0, 1] uniform distribution

Probability of drawing a number x less than X: Pr(x < X) = X
Probability of drawing a number x higher than X: Pr(x > X) = 1 − X
Probability of drawing the number X1 ∈ [0, 1]: Pr(x = X1 ) = 0
Expected value of x conditional on being less than X: E(x | x < X) = 21 X

Each bidder knows his own value, but only knows that the other bidder’s value is uniformly distributed
on [0, 1]. The bidding is done using a Japanese auction. That is, bidders maintain a signal showing that
they are still in the auction, for example, by holding their hands in the air. When the price goes above
the maximum bid a bidder is wiling to make, the bidder discontinues his signal (dropping his hand.) The
auction has winner when there is only one bidder left. This implies that the winner pays the price at
which the next to the last bidder dropped out. A bidding strategy is a price, p, at which a bidder will
drop out. It seems logical that the optimal bidding strategy for a bidder will be a function of his private
value. Lets recognize that by writing the optimal bidding strategy as p∗i (vi ), where vi is the private value
for bidder i = 1, 2. Thus, our search for an optimal bidding strategy is a search for the function p∗i (vi )
that “maps” value into a price.

2.2 Optimal bidding in a private value auction

This is the simplest of all the cases we will look at. The optimal bid is to stay in the auction until the
price reaches the private value. Using the notation established above, we have: p∗i (vi ) = vi . Why is this
optimal? Well, because it is not optimal to quit at prices higher than vi since this would imply a loss of
(vi − pi ) < 0 if you won the auction. It is not optimal to quit at prices lower than vi since by staying in
the auction you have a chance of winning at a price lower than your valuation—which implies a positive
gain. Example 1 shows a simple numerical illustration of this argument. Appendix A contains a formal
proof of p∗i (vi ) = vi .

Example 1 Private value auction without toehold

Suppose bidder 1 has a private value of 10 (v1 = 10.) If she bids higher than 10, say 12, and wins the
auction she will realize a loss of −2. For any price higher than 10, she will realize a loss if winning—hence,
it can never be part of an optimal bidding strategy to bid beyond her private value.

Suppose she quit at a price below 10, say 8, while there are other bidders that are still active. She will
then not win the auction and realize a profit of zero. By remaining in the auction a little bit beyond 8
there is a chance that she will win—resulting in an expected profit greater than zero. Hence, it can never
be optimal to quit below your private value (when other bidders are active.)

2.3 Optimal bid with toehold

A small ownership in the target prior to launching a tender offer is referred to as a “toehold.” Assume
that bidder 1 has a toehold θ1 < 0.5 and that bidder 2 does not have a toehold. This will change the
optimal bidding strategy for the toeholder. The reason is that bidder 1 will sell his toehold to bidder 2 if
bidder 2 wins the auction. This gives bidder 1 a strong incentive to make sure that bidder 2 pays a high
price whenever he wins.
Following the logic of section 2.2, the optimal strategy for the bidder without a toehold is to remain
in the auction until the price reaches his private value (p∗2 = v2 .) For bidder 1, it will still not be optimal
to quit at a price lower than his private value. However, it will be optimal to remain in the auction at
price levels that exceeds the private value. Assuming that the price has reached the valuation of bidder 1
and bidder 2 is still active, it will be profitable for bidder 1 to remain in the auction since this drives up
the price bidder 2 will pay for the toehold, while only resulting in a very small probability of winning the
target at this price (notice that the price now is higher than v1 , so bidder 1 really do not want to acquire
the target). In other words, it is optimal for the toeholder to bid the price “up under” the competing
bidder.
Bidding strategies 3

Deriving the optimal bidding strategy for the toeholder. From the perspective of bidder 1 (the
toeholder,) the problem is to choose a price level p1 at which it will be optimal to quit the auction if
bidder 2 is still active. First, we need to determine what we should assume about bidder 2’s behavior. It
seems reasonable to assume that bidder 2 will follow the optimal bidding strategy for a bidder without
a toehold, that is, p∗2 = v2 . From bidder 1’s perspective, this implies that bidder 2’s maximum bid (i.e.,
how long bidder 2 will stay in the auction) is uniformly distributed on [0, 1]. In other words, bidder 1 can
view p2 as a random variable. Second, bidder 1 needs to determine the price level, p1 , that maximizes his
expected profit in the auction. If bidder 1 remains in the auction until the price reaches p1 , the expected
profit for bidder 1 can be written as follows (please do not freak out!—this is not as complicated as it
looks):
Pr(p1 < p2 ) [θ1 p1 ] + Pr(p1 > p2 ) [v1 − (1 − θ1 )E(p2 | p2 < p1 )]
Let me explain the components of this expression. First, Pr(p1 < p2 ) is the probability that bidder 1
loses the auction. In other words, if bidder 1 quits at p1 , Pr(p1 < p2 ) is the probability that the optimal
bid for bidder 2 is higher than p1 (in which case bidder 1 loses.) If bidder 1 drops out at p1 and bidder
2 wins the auction, bidder 2 pays p1 for bidder 1’s toehold θ1 . Thus, the first term is the value to bidder
1 if he loses the auction times the probability that this happens.
Second, Pr(p1 > p2 ) is the probability that bidder 2 optimally quits before p1 —leaving bidder 1 as the
winner. The term [v1 − (1 − θ1 )E(p2 | p2 < p1 )] is the expected profit to bidder 1 conditional on winning
the auction. The expected profit is computed as the difference between the private value, v1 , and the
expected price, E(p2 | p2 < p1 ), paid for the fraction of the company, (1 − θ1 ), that bidder 1 does not
already own. Remember that when bidder 1 wins the auction, he will pay the price at which bidder 2
drops out. Thus, the expected price is just the expected value of the random variable p2 conditional on
p2 being less than p1 .
Using Table 1, we have Pr(p1 > p2 ) = p1 , Pr(p1 < p2 ) = 1 − p1 , and E(p2 | p2 < p1 ) = (1/2)p1 . Thus,
we can rewrite bidder 1’s expected profit as:
 
1
(1 − p1 )θ1 p1 + p1 v1 − (1 − θ1 ) p1
2

The optimal strategy for bidder 1 is the p1 that maximizes the above expected profit. So, we take the
partial derivative of the expected profit with respect to p1 . This gives the first order condition:
v1 + θ 1
p∗1 =
1 + θ1
This is bidder 1’s optimal bidding strategy as a function of the toehold and his private value. That is,
given that bidder 2 is still active, bidder 1 should bid up to p∗1 to maximize the expected profit from
participating in the auction.
To see that this bidding strategy implies that the toeholder optimally bids more than his valuation,
we add and subtract v1 on the right hand side and rearrange to get:

θ1 (1 − v1 )
p∗1 = v1 +
1 + θ1
That is, bidder 1 bids more than his private value for all private values less than one. Since, we assumed
that v1 is uniformly distributed on [0, 1] this implies that he almost always overbids. The intuition for
this result is as follows: When the price has reached v1 bidder 1 will consider two effects of continued
bidding.
1. Continued bidding will drive up the price at which he can sell his toehold to bidder 2.
2. Continued bidding implies that there is a chance that he will win the auction at a price higher than
v1 —hence realize negative profit.

However, by bidding only a little bit higher than v1 , say up to p0 > v1 , there is only a very small
probability that bidder 2 happens to optimally quit between v1 and p0 . Thus the expected loss from
bidding up to p0 is very small while the expected gain is (p0 − v1 )θ1 almost for sure.2
2 Suppose the probability that bidder 2 quits in the interval [v , p0 ] is q ≈ 0. Then, the expected loss from continued
1
bidding is (p0 − v1 )q ≈ 0 while the expected gain is (p0 − v1 )(1 − q)θ1 ≈ (p0 − v1 )θ1 .
Bidding strategies 4

3 Common value
In a common value auction, the value of the item being sold is the same for all bidders. If I were to
auction off the contents of my wallet, this would be a common value auction.3 The bidders for my wallet
would be allowed to observe the size of my wallet to form an opinion on how much it contains in term
of valuables. In this situation, each bidder would presumably come up with a different estimate of the
“true value” of my wallet. Thus, a common value auction involves an object with a common value for
all bidders, but, bidders have different estimates of the common value. In a takeover context, think of
common value as the intrinsic value of a target. Bidders form an opinion on the value of the target by
forecasting free cash flow, estimating cost of capital, and discounting to get an estimate of this intrinsic
value. Each bidder knows that his valuation and all the other bidders’ valuations are uncertain estimates
of the intrinsic value.
In the 1950s the US federal government started to auctions off production rights to oil and gas deposits
on offshore public land. The patch of land to be auctioned off is referred to as a “tract”. A tract typically
consists of 5,000 acres. Private oil companies bid for the rights to drill for oil on the tract. Prior to
bidding the oil companies were permitted to gather information about the tract using seismic surveys
or off-site drilling (no on-site drilling was allowed). Initially, these offshore oil wells were unprofitable.
The problem turned out to be the bidding process together with the large uncertainty embedded in the
seismic information used by oil companies to value the oil tracts.4
To illustrate the problem faced by the oil companies, consider the following simple example. Suppose
the intrinsic value of a tract is $22.5 million net of the costs to get the oil out of the ground.5 There
are four oil companies bidding for the tract. Based on their private seismic surveys they have come up
with four different intrinsic values net of costs: $15 million, $20 million, $25 million and $30 million.
Notice that the average value of the four estimates is equal to the intrinsic value of the tract—thus, the
oil companies get it right on average. Suppose the bidding for the tract went on like the following: At
$15 million the first firm drops out, at $20 million the second firm drops out, and at $25 million the third
firm drops out. Thus, the winner is the firm that valued the tract at $30 million and they are happy
with the outcome because they only paid $25 million. The problem is that the tract only is worth $22.5
million which implies that they will incur a loss of $2.5 million from the tract. The winner of this auction
has suffered what is called the “Winner’s Curse.” In this auction, the prize went to the firm with the
most optimistic view of the value of the object up for sale. Unless bidders take the “Winner’s Curse” into
account, the winner of a common value auction will be the person that has overestimated the value the
most. An optimal bidding strategy, though, will take the “Winner’s Curse” into account by “shaving”
the bids—that is, bid less than the expected value of the object.

3.1 Optimal bidding in a common value auction

This time, assume that there are three bidders for a target. The auction mechanism is still a Japanese
auction. The bidders have analyzed the target and established value estimates v1 , v2 , and v3 . The value
estimates are independent draws from some commonly known continuous distribution. The common
value for the target is:
1
v = (v1 + v2 + v3 )
3
All bidders realize that the target value is determined in this way and will bid accordingly.6
We will be looking for a symmetric equilibrium. That is, the bidders use the same optimal bidding
strategy as a function of their valuation. Therefore, two bidders with the same value will quit from the
auction at the same price. Also, a bidder with a low estimate will quit before a bidder with a higher
estimate. Imagine that we rank the value estimates according to their value as follows: v(3) < v(2) < v(1) .
Thus, v(1) is the bidder with the highest valuation. This could be either bidder 1, bidder 2, or bidder 3.
Notice that the bidders will, of course, not know this ranking. The first bidder to quit in the auction will
be bidder v(3) and this bidder will optimally quit when the price reaches v(3) . To see why this is optimal,
consider the following two arguments:
A1 If no other bidder has quit and bidder v(3) continues to bid beyond v(3) , say up to p0 > v(3) , and
find himself as the winner, it must be because all other bidders have estimates lower than or equal
3 It
would also be a low-value auction—which, of course, is beside the point.
4 See
“Competitive bidding in high risk situations,” Capen, Clapp and Campbell, Journal of Petroleum Technology, 1971.
5 The intrinsic value of a tract depends on the amount of oil and the oil price.
6 This is just a simple way to get the model to reflect that all bidders’ estimates are unbiased, although uncertain,

estimates of the target value.

Bidding strategies 5

to p0 . At best, they all have estimates p0 . But then, v = (1/3)(v(3) + p0 + p0 ) < p0 . Thus, winning
at p0 for bidder v(3) implies a loss. Making p0 arbitrarily close to v(3) shows that it will never be
optimal to quit at any price above v(3) .

A2 Define prices p0 and p00 such that p0 < p00 < v(3) . Consider the situation when no bidder has
quit and the price has reached p0 . If bidder v(3) quits at p0 the expected profit is zero. The
reason for this is that there is zero probability that the other two bidders optimally quit at p0 .
If bidder v(3) instead decides to continue to bid up to p00 there is a positive probability that the
other two bidders quit between p0 and p00 , in which case bidder v(3) makes a profit that at worst is:
(1/3)(v(3) + p00 + p00 ) − p00 > 0. Making p0 arbitrarily close to v(3) establishes that it will never be
optimal to quit at any price below v(3) .
Next we derive the price at which we should observe the second quit. All bidders understand what the
equilibrium bidding strategies are, therefore, they know that the first quitter had a value estimate of
v(3) . Following the logic of A1 and A2, the other bidders will remain in the auction until they make
zero profit if they quit and win the auction but will make a negative profit if they continue and win the
auction. The next bidder to quit the auction will be bidder v(2) and this bidder will quit when the price
reaches
1
p∗ = (v(3) + v(2) + v(2) ).
3
If bidder v(2) quits at this price and find himself as the winner of the auction—it implies that the other
bidder quit at the same price. The other bidder will only quit at the same price if he has the same value
estimate as bidder v(2) . Thus the value of the target, conditional on bidder v(2) winning, is p∗ . Winning
the target at any price above p∗ would result in a loss for bidder v(2) —hence he optimally quit at p∗ .
Since v(2) is the next to the last bidder to quit, bidder v(1) will win the auction and pay p∗ for the target.
The profit earned by the winning bidder is:

(1/3)(v(3) + v(2) + v(1) ) − p∗ =

(1/3)(v(3) + v(2) + v(1) ) − (1/3)(v(3) + v(2) + v(2) ) =
(1/3)(v(1) − v(2) ) > 0

The are three crucial insights here. First, the equilibrium bidding strategies prescribe that bidders should
quit at the price where they expect to make no profit as winners at the current price. Second, bidder v(2)
only cares about the value of the target conditional on being the winner. When there are two bidders
that remain active, and one bidder decide to quit at v(2) and then find himself as the winner of the
auction—it means that the other bidder quit at the same price and that the other bidder has the same
value estimate.7 This determines p∗ above. Third, the equilibrium bidding strategies take the “Winner’s
Curse” into account. Conditional on the price having reached v(2) , the expected value of the target is
higher than v(2) , since the other bidder’s signal is at least v(2) (otherwise he would already have dropped
out) and on average it will be higher than v(2) . However, it is still optimal for bidder v(2) to drop out at
v(2) . Again, the reason is that he is not concerned with the expected value of the other bidders signal,
but with the expected value of the other bidder’s signal conditional on winning the auction.

3.2 Optimal bid with small strategic advantages8

A bidder that receives a small “bonus” if he wins an auction will have an advantage relative to bidders
that does not receive such a bonus. Even a very small advantage in a common value auction can result
in a huge increase in the probability of winning the auction and also result in a very low winning bid.
The Los Angeles PCS license in the Airwaves Auction has been viewed as an example of the big effects
caused by a relatively small advantage. Pacific Telephone was bidding with an advantage in this auction.
They had a database of potential local costumers for the new wireless phone service, its brand-name was
well known in the region, and its executives was familiar with California. Pacific Telephone ended up
winning the auction at $26 per head of population. This compares very favorable to the price of $31 paid
in Chicago—even though Chicago generally was viewed as a less promising area for the new service.
7 In a Japanese auction it is possible to be the winner even if you quit when there are other bidders that are active. If

all the remaining bidders quit at exactly the same price, the auctioneer must have some mechanism to allocate the object.
This could, for example, be a random draw among the bidders that remained in the auction to the end and quit at the
same price.
8 This section draws extensively on “Auction with Almost Common Values: The “Wallet Game” and its Applications”,

by Paul Klemperer, European Economic Review 1998, 42(3-5), 757–769.

Bidding strategies 6

To illustrate how a small bonus affects optimal bidding consider the following simple example. Two
bidders are given value signals vA and vB . The signals are independent and continuously distributed on
[v, v]. The object they are bidding for is worth vA + vB . Assume that vA happens to be greater than
vB . Without advantages to any of the bidders, we know (using the logic from A1 and A2 above) that
bidder B will drop out at 2vB . Thus, bidder A wins the auction and pays 2vB . This gives him a profit of
vA − vB > 0. If you are still reading, take a deep breath, the next paragraph is going to get your eyeballs
rolling.
Next, change the rules of the auction to include a small prize x given to bidder B if he wins the
auction. Given that v is the highest possible signal that any bidder can get, bidder A should never bid
more than vA + v. Whenever bidder B gets a signal vB that is greater than v − x he should never quit.
The reason for this is:
i. At any price P reached in the auction, bidder B knows that

P ≤ vA + v ⇒ vA ≥ P − v

ii. The profit for B if winning at P is x + vA + vB − P (remember that B is getting a prize x if he wins
the auction). Using the fact that vA ≥ P − v, the profit for B is at least as big as

x + (P − v) + vB − P = x − v + vB

iii. This profit is positive when vB > v − x.

Thus, as long as vB > v − x, the profit to bidder B is always positive and he should never quit. Taking
this into account, bidder A should never bid more than vA + (v − x). If he does and wins the auction,
it implies that bidder B must have had a value vB less than v − x, in which case bidder A would realize
a negative profit. This, in turn, implies that whenever bidder B gets a signal vB that is greater than
v − 2x he should never quit. The reason for this follows the logic of arguments (i) through (iii) above.
The chain of arguments can be repeated until you have showed that bidder A will never bid higher than
the lowest possible value of the object—which from bidder A’s perspective is vA + v. Bidder B will, of
course, realize this and will never quit. Bidder B ends up winning the object for sure, pay a price equal
to vA + v, and make a profit equal to vB + x − v > 0.
There are two important insights here. First, bidder B will win the auction even if his value estimate
vB is lower than bidder A’s value estimate. Second, bidder B will win the auction with probability 1
regardless of the size of the “strategic advantage.” It is in this sense a small advantage for one bidder
can have a huge impact on the outcome and price realized in the auction.

Bidding for a takeover target with a toehold

Consider two bidders that are bidding for a target. Let p∗1 and p∗2 be the prices at which bidder 1 and
bidder 2, respectively, would optimally quit in the no-toehold case. Assume that bidder 1 has a toehold,
θ1 < 0.5, in the target and that bidder 2 does not have a toehold. The toehold of bidder 1 gives him a
strategic advantage in the auction for the same reason as the prize x gave bidder B an advantage (see
the section above.)
The toehold of bidder 1 implies that bidding the price  higher than p∗1 earns him a fraction θ1 of 
with a probability very close to 1, but with a really small probability σ he wins the auction and loses
(1 − θ1 ). Since,
(1 − σ)θ1  − σ(1 − θ1 ) = (θ1 − σ) > 0
for small ,9 bidder 1 optimally bid higher than p∗1 . For bidder 2, this implies that for any price at which
bidder 1 quits the corresponding value estimate, v1 , is lower than in the no-toehold case. Therefore, bidder
2 optimally bids less than p∗2 . This again reduces the winner’s curse problem for bidder 1, resulting in
an even higher optimal bid. In turn, this reduces the optimal bid for bidder 2. This argument can be
repeated over and over again. As in the previous section, it will not be optimal for bidder 2 to bid
beyond the lowest possible value the target can have from his perspective. If we model target value as
(1/2)(v1 + v2 ) and assume that the value estimates are drawn from the uniform [0, 1] distribution, the
lowest possible value will be half his own valuation, (1/2)v2 .

9 Notice that σ is a function of . The bigger you take  the bigger will σ be.
Bidding strategies 7

A Private value no toehold

Using the model from section 2.1, the claim is that the optimal bidding strategy is to bid up to your
private value as long as other bidders remain active. The trick will be to argue that it is never optimal
to quit below your private value and that it is never optimal to quit above your private value.
First, we show that it is not optimal to quit below v1 for bidder 1. Suppose the price has reached
p00 < v1 and that bidder 2 is still active. If bidder 1 quits she will get zero profit. Define another price
p0 such that p00 < p0 < v1 . Since v2 is continuously distributed on [0, 1], there is a positive probability
that bidder 2 will quit between p00 and p0 if bidder 1 decides to remain in the auction. If bidder 2 quits
between p00 and p0 , bidder 1 will make a profit of at least vi − p0 > 0. Thus, when the price reaches p00 ,
the expected profit for bidder 1 from remaining in the auction until the price reaches p0 is positive. You
can pick p00 as close you want to v1 and the above argument still goes through.
Second, we show that it is not optimal to quit above v1 for bidder 1. Suppose the price reaches v1
and bidder 1 decides to remain in the auction until the price reaches p00 > v1 . Since there is a positive
probability that bidder 2 quits at a price between v1 and p00 , the expected value for bidder 1 from
remaining in the auction until p00 is negative. Again, you can pick p00 as close you want to v1 and the
argument still goes through.