Bidding for an Item of Unknown Value The item you see will be won by the highest sealed bid. Write down your: 1) best value estimate, 2) lower and upper estimate bounds, and 3) optimal sealed bid. Now let’s quickly explore the cross section (i.e. distribution) of estimates and bids. 1

BIDDING (continued) 2 V _B_B Estimate Distribution Bid Distribution All bidders discount bids below their estimates. Nonetheless, when the value of the item is highly uncertain, a winning bid (drawn from the right tail) will exceed the true value of the item. w w w w

Pitfalls in Assessing Risks 3 The proper “language” of uncertainty is PROBABILITY. But even those fluent in the language (statisticians, actuaries) can unknowingly fall prey to systematic errors and biases in risk assessment. Or how preferences can cause biases in risk assessments. 1. Self-serving Biases and Wishful Thinking Two experiments. Shell Oil’s Mispredictions.

4 Or the psychology of clinging to “old” beliefs. 2. Status Quo Biases The weather tomorrow will be like the weather today. More Pitfalls Example: Scientific beliefs. Sighting Uranus.

More Pitfalls 5 3. Acquiring a Company Firm A will make a cash tender offer for Firm T. However, T’s value is highly uncertain ranging from $0 to $100 per share. T knows its own true value. Due to synergies, the firm is worth 50% more under A’s management and control. Possible Values under T $ | | | | | | | $ Possible Values under A

Acquiring a Company (continued) 6 What is A’s most profitable bid for T? Most respondents (72%) offer between $51 and $71 per share. But once again all these offers fall prey to the WINNER’S CURSE! If A offers $50 per share, only “low-value” ($0 - $50) firms accept. The average value of such firms is $25 under T and still only $37.5 per share under A. Firm A gets less than it paid for!

7 Should NASA have foreseen the risk of O-Ring failure during a low-temperature launch? 4. The 1986 Challenger Disaster There had been O-Ring wear in 7 of the 30 prior launches at the following temperatures: More Pitfalls Is O-Ring wear correlated with low temperatures? Results for all 30 Launches? Wear None Total T > 65 3 T < 65 4 Total