Faculty of Economics and Business Administration Publications Database

Prospect theory in a dynamic game: Theory and evidence from online pay-per-bid auctions

Natter, Martin
Volume: 164
Pages: 215 - 234
ISSN-Print: 0167-2681
Year: 2019
Keywords: Internet auction, Prospect theory, Dynamic game, Pricing, Penny auction

Abundant evidence exists that expected utility theory does not adequately describe de-
cision making under risk. Although prospect theory is a popular alternative, it is rarely
applied in strategic situations in which risk arises through individual interactions. This
study fills this research gap by incorporating prospect theory preferences into a dynamic
game theoretic model. Using a large field data set from multiple online pay-per-bid auc-
tion sites, the authors empirically show that their proposed model with prospect theory
preferences makes a better out-of-sample prediction than a corresponding expected utility
model. Prospect theory also provides a unified explanation for two behavioral anomalies:
average auctioneer revenues above current retail prices and the sunk cost fallacy. The em-
pirical results indicate that bidders are loss averse and overweight small probabilities, such
that the expected revenue of the auction exceeds the current retail price by 25.46%. The
authors illustrate and empirically confirm a managerial implication for how an auctioneer
can increase revenue by changing the details of the auction design.