Level-k Auctions: Can a Nonequilibrium Model of Strategic Thinking Explain the Winner’s Curse and Overbidding in Private-Value Auctions?

This paper proposes a structural nonequilibrium model of initial responses to incomplete-information games based on “level-k” thinking, which describes behavior in many experiments with complete-information games. We derive the model’s implications in first- and second-price auctions with general information structures, compare them to equilibrium and Eyster and Rabin’s (2005) “cursed equilibrium,” and evaluate the model’s potential to explain nonequilibrium bidding in auction experiments. The level-k model generalizes many insights from equilibrium auction theory. It allows a unified explanation of the winner’s curse in common-value auctions and overbidding in those independent-private-value auctions without the uniform value distributions used in most experiments.