Consider an oil company that bids for the rights to drill in offshore areas. The value of the right to drill in a given offshore area is highly uncertain, as are the bids of the competitors. This...

Consider an oil company that bids for the rights to drill in offshore areas. The value of the right to drill in a given offshore area is highly uncertain, as are the bids of the competitors. This problem demonstrates the “winner’s curse.” The winner’s curse states that the optimal bidding strategy entails bidding a substantial amount below your assumed value of the product for which you are bidding. The idea is that if you do not bid under your assumed value, your uncertainty about the actual value of the product will often lead you to win bids for products on which you (after paying your high bid) lose money. Suppose Royal Conch Oil (RCO) is trying to determine a profit-maximizing bid for the right to drill on an offshore oil site.


The actual value of the right to drill is unknown, but it is equally likely to be any value between $10 million and $110 million. Seven competitors will bid against RCO. Each bidder’s (including RCO’s) estimate of the value of the drilling rights is equally likely to assume any number between 50% and 150% of the actual value. Based on past history, RCO believes that each competitor is equally likely to bid between 40% and 60% of its value estimate. Given this information, what fraction (within 0.05) of RCO’s estimated value should it bid to maximize its expected profit? (Note: Use the RISKUNIFORM function to model the actual value of the field and the competitors’ bids.)