First price auctions under prospect theory with linear probability weighting

Abstract

Overbidding in first-price sealed-bid auctions is a well-known result in the auction theory literature. For the possible reasons behind this phenomenon, economists provided many explanations; such as risk aversion, regret theory, and subjective probability weighting. However, for subjective probability weighting to explain overbidding, the probability weighting function (PWF) is needed to be underweighting all probabilities. Such a function is not in accord with PWFs in the prospect theory literature as it suggests a specific function which satisfies certain properties. In this paper we investigate, to what extent prospect theory is able to explain overbidding by using a linear PWF satisfying all of the axiomatic properties (Currim and Sarin, 1989). Moreover, we introduce a non-zero reference point, fully utilizing prospect theory. Our results show that, subjective probability weighting alone is unable to explain overbidding. However, with the non-zero reference point assumption, we obtain partial overbidding.