What is a Dollar Auction

Designed by economist Martin Shubik, a dollar auction illustrates a paradox of rational choice theory which assumes that a person will always make the most logical decision. 

BREAKING DOWN Dollar Auction

A dollar action is a simple game, where two participants bid on a dollar bill. The highest bidder receives the bill. However, the loser must pay the amount that they offered as well. When bidding in the game begins to approach, or go beyond, $1 the player' game goal changes. Instead of maximizing their potential gain, players now try to minimize their potential loss. 

A dollar auction starts with an auctioneer accepting the initial bids of two participants. After that, it does not make sense for them to stop bidding up the price. For example, if an auction leads to Participant A bidding 90 cents, followed by a $1 bid from Participant B, Participant A can either offer $1.01 and lose 1 cent or drop out of the auction and lose 90 cents. 

Bidding more than a dollar, for a dollar, is not logical. At the same time, losing 90 cents is not as smart as losing 1 cent.

In this game, the rational move would be to place the bid which leaves Participant B in a similar situation. In other words, either bid $1.02 and lose 2 cents or drop out and lose the dollar.

In theory, the bidding process could continue in perpetuity as long as both players remain committed to winning the dollar.

What ‘Dollar Auction’ Illustrates

The dollar auction shows how rational behavior can lead to an undesirable outcome. In that sense, it is similar to the more widely known prisoner's dilemma, which stipulates that rational individuals might not cooperate with each other, even when it appears that it would be in their best interest to do so.

American economist Martin Shubik invented the dollar auction to reveal the consequences of what he called the “escalation of commitment.” Shubik, a pioneer in game theory, posited that the dollar auction shows how people can become obsessed with the idea of losing, even though they know that they can still lose by winning. 

In his 1971 articleThe Dollar Auction game: A paradox in noncooperative behavior and escalation, Shubik indicated that he particularly enjoyed seeing the game’s dynamics play out in party settings and front of a large crowd. “Once two bids have been obtained from the crowd, the paradox of escalation is real. This simple game is a paradigm for escalation. Once joining the contest, the odds are that the end will be a disaster to both.”