Project 2-Guidelines

Recall- Class Project-Goals  Determine what would be expected to happen if each company bid the same amount as its signal.  Determine the Company 1 bid under several uniform bidding strategies, and explore the expected values of these plans.  Find a stable uniform bidding strategy that could be followed by all companies, without any chance for improvement.

Recall-Project Assumptions Assumption 1. The same 18 companies will each bid on future similar leases only bidders for the tracts. Assumption 2. The geologists employed by companies equally expert on average, they can estimate the correct values of leases. each signal for the value of an undeveloped tract is an observation of a continuous random variable, S v,

Recall-Project Assumptions Assumption 3. Except for their means, the distributions of the S v ’s are all identical (The shape /The Spread) Assumption 4. All of the companies have the same profit margins

Strategies for bidding on an Oil Lease Strategy 1 -Bid your signal. What will happen? Give reasoning for your analysis Strategy 2(First Plan) -Subtract Winner’s curse from your signal to obtain bid. Assume all other companies do the same process. What will happen? Give reasoning for your analysis Strategy 3(Second Plan) -Subtract Winner’s curse and Winner’s blessing from your signal to obtain bid. Assume all other companies do the same process. What will happen? Give reasoning for your analysis

Strategies for bidding on an Oil Lease Strategy 4 -Find a optimal adjustment for company 1. Assume all other companies Subtract Winner’s curse and Winner’s blessing from their signals to obtain their bids. Strategy 5 -Find a optimal adjustment for company 1. Assume all other companies Subtract Winner’s curse from their signals to obtain their bids. Strategy 6 -Determine a stable Nash equilibrium bid. This stable strategy is such that any company will not have any incentive to deviate from

Strategy 1 -Bid your signal. What will happen? Give reasoning for your analysis The company (highest signal) will submit the highest bid-> win the lease. Under this plan, our company would submit a bid of its signal, s 1 = $121,600,000 “Winner’s Extra Profit” is almost always negative. That is, the winning company will not get its needed fair return on the lease. The mean of the 18 signals for a new lease = the actual value of the lease.Because for example, historical auction 1 the mean lease signal=85.3 M & proven value =91M (Assumption 2) Hence, the highest signal will almost always be well above the value of the lease and the winning company will have paid too much for the drilling rights. This is called the winner’s curse. WC=avg of the maximum error column

Strategy 2(First Plan) -Subtract Winner’s curse from your signal to obtain bid. Assume all other companies do the same process. What will happen? Give reasoning for your analysis defeat the winner’s curse. estimate the expected size of the curse Let C be the continuous random variable which gives the largest number in a sample of 18 observations of R(error). E(C)=winner’s curse=avg. of the maximum error column If a company bids its signal and wins the auction, it can expect, on average, to fall $22,600,000 below its needed fair return on the lease. If each company bids 22.6 million dollars less than its signal, then any one of the companies is equally likely to win the auction, and there will be no winner’s curse. Under this plan, our company would submit a bid of  22.6 million dollars, that is $99,000,000

Strategy 3(Second Plan) -Subtract Winner’s curse and Winner’s blessing from your signal to obtain bid. Assume all other companies do the same process. What will happen? Give reasoning for your analysis In an auction where the highest bid wins, any amount that the winner pays above the second highest bid is wasted. Let B be the continuous random variable which gives the difference between the largest and second largest errors in a random set of 18 observations of R. E(B)=winners blessing=average of the difference column=5.8M the winning company will, on average, pay an unnecessary premium of 5.8 million. This leads to another possible bidding strategy, that we will call the Second Plan. Each company could bid $22,600,000 + $5,800,000 = $28,400,000 less than its signal. Under this plan, our company would submit a bid of  28.4 million dollars, that is 93.2M

on the project Probability, Mathematics, Tests, Homework, Computers Bidding on an Oil Lease Simulating, Focus The larger the expected value of Company 1’s adjustment, the better is the long term effect of that bidding plan for us. reduce by both the winner’s curse and blessing for Company 1 and all other companies. each company has approximately the same chance of winning, and, if a company wins, it can expect an extra profit that is close to the 5.8 million dollar winner’s blessing. Auction Focus.xls  TI (material continues) Class Project C

Strategy 4 -Find a optimal adjustment for company 1. Assume all other companies Subtract Winner’s curse and Winner’s blessing from their signals to obtain their bids. steps 1. Enter the sum of the WC & WB as the signal adjustment for all other companies cell 2. Change company 1 signal adjustment cell to get a set of expected values for company record results of expected value for company 1 How to find good adjustment points(10 points ) for company1? For example, If your WC=23,you could use 25,27,29,31,33 and 21,19,17,15 4. enter each good adj. ->hit F9(to recalculate)->manually record the expected values & create a table for company 1

on the project Probability, Mathematics, Tests, Homework, Computers Bidding on an Oil Lease for Company 1 must find the maximum expected value of adjustment(assuming that all other companies subtract both the curse and blessing) this best adjustment, acb Strategy 4- Constructing f(a) function

 copy from the sheet Strategy in Auction Focus.xls.  Let f(a) be the expected value for Company 1 for subtracting a million dollars from its signal, assuming that all other companies adjust their signals by both the curse and blessing.  Fit a 4 th degree polynomial trend line, which we will use as an approximate formula for the unknown function f.  Use solver to find the best adjustment f(a) function Strategy 4

This is the real world of business,competitors may also elect to subtract less than 28.4 million dollars from their signals. there is a strong incentive for individual companies to deviate from the strategy and subtract less than the curse and blessing. Company 1’s best adj million is not itself a stable strategy.

Strategy 5 -Find a optimal adjustment for company 1. Assume all other companies Subtract Winner’s curse from their signals to obtain their bids. steps 1. Enter the WC as the signal adjustment for all other companies cell 2. Change company 1 signal adjustment cell to get a set of expected values for company record results of expected value for company 1 How to find good adjustment points(10 points ) for company1? For example,If your WC=23,you could use 25,27,29,31,33 and 21,19,17,15 4. enter each good adj. ->hit F9(to recalculate)->manually record the expected values & create a table for company 1

on the project Probability, Mathematics, Tests, Homework, Computers Bidding on an Oil Lease Simulating, Focus  TI Auction Focus.xls (material continues) Class Project C for Company 1 must find the maximum expected value of adjustment(assuming that all other companies subtract both the curse and blessing) this best adjustment, a c Strategy 5 Constructing g(a) function

 USE the sheet Strategy in Auction Focus.xls.  Let g(a) be the expected value for Company 1 for subtracting a million dollars from its signal, assuming that all other companies adjust their signals by curse.  Fit a 4 th degree polynomial trend line, which we will use as an approximate formula for the unknown function g.  Use solver to find the best adjustment the use of Solver in Strategy shows that g( ) = 0. Hence, a c = million dollars. Company 1’s best response to an adjustment of 22.6 million dollars by all other companies is to lower its signal by the considerably larger amount of $27,599,000. g(a) function Strategy 5

if we know what all other companies plan to do. Moreover, this same information is available to all of the bidders. Need a stable strategy??? If all companies made such a stable adjustment to their signals, then there would be no incentive for anyone to alter the strategy. A stable bidding strategy is also called a Nash equilibrium

Strategy 6 How? (a)Use Auction Equilibrium.xls(. (b)FOLLOW THE INSTRUCTIONS IN THIS FILE! (c)Enter appropriate values in cells B10 through E10. (d)Enter a logical value in cell E39. Run the macro Optimize. (the first logical value to use- (2wc+wb)/2 (e)Enter another logical value in cell E39 and press the key F9.. record numbers in a table. (f)See table (g)Find the stable adj for strategy 6

MUST Download new file Link on class webpage

Strategy 6 Company 1 Optimal Adjustment, a max (use 4 decimals) All Other Companies Adjustment Subtracted From Signal New logical value ( )/2= Avg of a max =final stable adj for strategy 6 first logical value to use for class project- (2wc+wb)/2=25.5

Extra Profit Extra profit is the amount by which the winning bid is below the fair value of a lease. Let X i be the random variable giving the extra profit gained by Company i. The sample of 10,000 simulated auctions is used to approximate E(X 1 ) and the average of E(X 2 ), E(X 3 ),..., and E(X 18 )