Dollar Auction

Economists make a lot of assumptions when they make their models. One of the biggest and most common assumptions they make is that people are rational. We’d like to think that people, capable of building cities and atomic bombs...of building a global civilization...and of destroying it in under a minute...are rational creatures.

The dollar auction runs where two people are bidding on a dollar. The winner will get the dollar, and the loser will have to pay up whatever their last bid was. So players aren’t only trying to win, they’re also trying to minimize what they might lose. Once the bidding goes above $1, it makes sense to keep bidding. For instance, if your last bid was $0.95, and the other player’s bid was $1, then it would make sense for you to bid $1.01 to avoid losing $0.95. If this kept going, with infinite bidding, then each player would bid one cent through eternity.

Like the Prisoner’s Dilemma, this game shows that the rational choice doesn’t always lead to what appears to be the most rational outcome, especially when people aren’t working together, and instead are working in their own self-interest. For instance, it’s not rational to bid more than $1 to earn $1, but each player in the dollar auction is incentivized to keep bidding one cent more when it passes the $1 mark. If they worked together and said “okay, this is silly, let’s stop” it would lead to a more “rational outcome,” but how would they decide who's the last person to bid, i.e. the winner?