Say we have a situation in which a seller is auctioning off one dollar to two buyers. The rule is that the both bidders must both pay their bids, but only the highest bidder will receive the dollar. Now, we assume that there is no collusion between the two buyers to slightly simplify the model.

To start, the first bidder will bid $.01, looking for a $.99 profit. The next bidder will bid $.02, looking for a $.98 profit. Now, the first bidder will look at his options. Either bid $.03 and make a $.97 profit, or stay at his previous $.01 bid and lose that money. This reasoning drives up the bids of both bidders, even past the price of the prize. The first bidder will bid $.99 and the second bidder with have a choice between bidding $1.00 and breaking even, or losing $.98. The bids will escalate to such a point that the $1 originally considered becomes insignificant compared to the ever-rising bids. This is called an irrational escalation of commitment.

It seems natural for human beings to take what is already lost and try to justify it. In this example, each bidder considers the amount that they bid previously and in an effort not to lose any more, bids higher. It doesn’t matter who ends up winning or losing this auction, both pay severe prices for their actions. This fallacy of judgment shows up in many real-world scenarios: manufacturers will keep unprofitable plants open at the expense of more profitable ones for the sole reason that it would be “a waste” to shut them down and lose the capital that went into them, researchers will continue to labor over projects that have already proven to be impractical and useless only because good money went into starting them, and wars will continue to be fought even though there is no resolution in sight.

There is no easy way to address this concern. At the end of the dollar auction, one buyer is going to have to bow out to the other and accept the larger loss in order to save both himself and the other bidder from losing any more to the ever-increasing cost of participating in a lost cause. It’s not to say that the dollar auction won’t be profitable to anyone or that past commitments should never enter into considerations for the future, but to take a sober look at what the dollar auction could become.

http://en.wikipedia.org/wiki/Irrational_escalation_of_commitment