How much do you think you should bid in the auction

Reference no: EM133461166

Case Study: Your firm is one of several companies participating in an auction for oil rights to a potentially valuable land tract in the Permian basin. The market value of the oil rights, which we denote by V, is the present value of the cash flows that the winning firm will earn by extracting any oil from the tract, net of all economic costs incurred for exploration, development and extraction (i.e., it is the net present value of discounted future economic profits). The market value of the tract will be the same regardless of who wins the auction, but its precise value is uncertain before the tract is developed. None of the participants in the auction knows the true value V at the time they bid. However, each participant receives an estimate of this value. This estimate is generated by the formula: Estimate = V + error The error (and hence the estimates) will differ from participant to participant. Each team's estimation error will be randomly drawn from a normal distribution whose expected value is 0 and whose standard deviation is $20 million. So, estimated values of V will match the value of the tract on average, but could be higher or lower. The auction will be a first-price sealed-bid auction. Each team will submit a bid, and the winner of the oil rights will be the highest bidder. The winner pays the amount of their bid and everyone else pays nothing. To summarize: • The oil has a true value of V dollars. No one knows that value at the time of the bidding. • Each team will receive an estimate equal to the true value of the oil plus an estimation error. The estimation error for each team will be number drawn from a "bell shaped" distribution with a mean of 0 and standard deviation of 20. • The high bidder wins the auction.

Questions: Imagine for now that your estimate of V is $400. Without getting too deep into any mathematical/statistical analysis, think about and answer these questions:

1. How much do you think you should bid in the auction? Explain the logic behind your suggestion.

2. What is the potential advantage of bidding HIGHER? What is the potential advantage of bidding LOWER?

Reference no: EM133461166

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