Top Price Doesn’t Mean Top Value

Whether it’s drafting an NFL player, ordering a bottle of wine, or hiring a new CEO to head your company, paying top dollar won’t ensure getting top value, according to Richard Thaler, Robert P. Gwinn Distinguished Service Professor of Behavioral Science and Economics. “In a lot of markets, the price for buying the ‘very best’ goes up very steeply with small increases in quality,” he said.

 

Looking at the last 17 years of draft picks in the National Football League, Thaler and B. Cade Massey, MBA ’03, PhD ’03, assistant professor of management at Duke University’s Fuqua School of Business, concluded the first rookie chosen is likely to be overvalued and overpaid. “Teams put too high a value on picking early,”Thaler said.“For every high draft pick who turns out to be a star, like Peyton Manning, who was taken with the first pick, there is another player like Ryan Leaf, who was taken with the second pick the same year.” Leaf, drafted in 1998 with an $11.25 million bonus, played poorly for several teams until he retired in 2002.

The culprit? Overconfidence, Thaler said. Teams that kept track of former predictions “would be shocked by what they found, namely that their ability to predict is not as accurate as they think,” he said. According to the study, comparing players who play the same position and were taken consecutively in the draft would show that the earlier pick has about a 53 percent chance of being better, in terms of games started. “But at the top of the draft, the first player taken might get paid twice as much as the second one. If you are told that player A costs twice as much as player B and has a 53 percent chance of being better, I think it’s clear which one to take,” Thaler said. According to the study, the most valuable player is around the 43rd pick.

Applying the research to the corporate world, he asked, “ Are superstar CEOs who make hundreds of millions of dollars a year worth it? Would a company be better off promoting someone inside the organization with only a modest raise and using the money saved to buy more ‘ blockers and tacklers?’”

Or, Thaler noted, consider fine wine. It’s possible to find good wine for $20 a bottle, very good wine for $50, and really excellent wine for $100. But some wine sells for $2,000 a bottle, he said. “It’s very unlikely that many consumers could discriminate between the $100 wine and the $2,000 wine,much less think the $2,000 wine was 20 times better. “

Still,” Thaler quipped, “if any readers want to prove me wrong by opening one of those bottles to share, please call!” The research drew the attention of the media last spring and was featured in the New York Times and the Economist .—P.H. with A.R.

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Richard H. Thaler will be the keynote speaker for the Tenth Annual Alumni Celebration Dinner on October 7, 2005.
Keynote: "Overconfidence vs. Market Efficiency in the National Football League Draft"

 

To read the paper “The Loser’s Curse: Overconfidence vs. Market Efficiency in the National Football League Draft” (.pdf), click here.

 

 

 

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