Optimal bid for a company worth double to you
Question
A company's current value is uniformly distributed on ; you do not know , but the owner does. You make a single take-it-or-leave-it offer . The owner accepts only if , and once you own the firm its value becomes . Which bid maximises your expected profit?
Short answer
Every bid earns zero in expectation, so you gain nothing by bidding (bid ). An accepted bid tells you , so the firm is worth to you on average, exactly what you paid: expected profit is . With any value uplift below every positive bid loses money (the winner's curse).
Adapted from Crack, Heard on the Street, Q1.50, p.19; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- Conditional Probability, Total Probability, and Bayes' Rule
- Worked Examples — Probability Trees, Monty Hall, and Bayesian Updating
- Expectation, Mean, and Variance
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