Reference Dependent Preferences and Overbidding in Private and Common Value Auctions

Abstract

This paper proposes a tractable model of reference dependent preferences to explain overbidding in private and common value auctions. It is assumed that the reference point is proportional to the value of the object and that losses are weighed more heavily than gains in the utility function. Equilibrium bidding strategies are derived for first- and second-price private and common value auctions. It is found that this model fits the data of all experiments analyzed better than a standard risk neutral model; moreover, it explains overbidding in private value auctions better than other alternatives. These results suggest that reference dependence, among other factors, might play a role in the widespread tendency of subjects to overbid in most experimental auctions.