A Must-Read!
February 17th, 2007If you're new here, you may want to get Mercury's Blog by Email or subscribe to my RSS feed. Thanks for visiting!
I’m sorry it’s been a while between posts, but I was knocked down last week by a particularly violent case of food poisoning… I now vow never to eat at the local Chinese takeaway again!
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I’d like to mention a book here that I think could be valuable for everyone that’s not a professional economist (and even those that are!), and wants to understand the nature of markets. It’s called Reinventing the Bazaar: A natural history of markets, written by John McMillan of Stanford’s Graduate School of Business.
Let me say first off that there’s a good reason this book is rated five stars by Amazon readers; it’s absolutely excellent! It’s written for a wide audience, and is able to include both theory and relevant examples that everyone should find familiar. What it aims to do is lay bare the spectrum of modern markets: how they work, why they work, why some don’t work, and the markets’ relationship to government. I recommend it here because it lays a fantastic foundation for why prediction markets are such incredible mechanisms for forecasting and revealing information.
The book opens not on the New York Stock Exchange, but in the Dutch city of Aalsmeer. It is here where a huge flower marketplace is operated, and where millions of dollars worth of flowers are purchased every day in an extremely efficient manner. That the book doesn’t focus solely on standard financial markets such as the NYSE is to its credit. It talks about real-life markets throughout the world-wide economy, such as a Middle East bazaar (hence the name), fishing grounds, the deregulated California energy markets, the famed auction of additional slices of the US frequency spectrum, and many more. More importantly it examines what makes those markets work, and what is required to make those markets work.
I’m also very impressed that there is no ideology here. Some authors writing a book on this topic could tend to write either a “markets can save the world, they just need to be freed from regulation” type book, or a “markets are the cause of all the worlds’ problems” type book. It is neither, and instead discusses how markets are indeed a powerful construct, but can be both well-built and resilient or poorly-built and unfair.
I’d like to quote a few paragraphs here that apply very directly to the prediction markets arena:
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(In a discussion about central planning and control)
A worker on the production line might observe quality defects that are apparent only on the shop floor, or a machine that is sometimes idle, or a surplus stock of raw materials that could be used. A middle manager might be aware of engineering problems in a new process, or a way of reassigning workers to increase productivity. Salespeople in the field learn about demand for the firms products. Much of the information about demand and costs that the top management needs for planning must come from below. Knowledge that is valuable to an organization is acquired by people - at all levels of the organization, including the lowest - as a by-product of their day-to-day duties.
Why does it matter that the source of the information is separated from the decision-making responsibility? People take advantage of any special knowledge they have acquired. Dispersed information within a hierarchy makes conflicts of interest inevitable. Information becomes distorted because of people’s incentives to exploit any informational advantages they have. “People are reluctant to share their information,” observed the head of a large French company. “Managers in particular seem to think it gives them extra power.” Middle managers “have an interest in husbanding information - and the power that goes with it.
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For a market to function well, you must be able to trust most of the people most of the time; you must be secure from having your property expropriated; information about what is available where at what quality must flow smoothly; any side effects on third parties must be curtailed; and competition must be at work. A multitude of mechanisms sustain these five key requisites of effective markets. Your trust in your trading partner rests on both the formal device of the law and the informal device of reputation. Your property rights are protected by the law and, in the case of your investments, by regulation. For you to be able to take your business elsewhere, there are channels for the flow of information, so you can locate others to deal with, and there are few impediments to starting up and running firms.
A market’s design, supporting these features, may evolve from below or be imposed from above; usually there is a bit of both. A workable structure provides rewards for good behavior and checks and balances to deter bad behavior, so people act honorably while following their self-interest. When markets are well designed - but only then - we can rely on Adam Smith’s invisible hand to work, harnessing dispersed information, coordinating the economy, and creating gains from trade.
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So to summarise, this book is an excellent resource for anyone that’s interested in how prediction markets work. Not just the markets themselves, but all of the supporting structures that markets require to operate properly are very well covered in this book.
I highly recommend it for anyone reading this blog!