Sunday, February 18, 2007

In Praise of Markets

Yet another new blog comes to my attention (my trusty searchers for references to Adam Smith worked through the night and found this one). It’s about markets and looks just great. These are often misunderstood, especially by aficionados of the neoclassical paradigm, and it is always good news to note someone who has taken a look at the phenomenon in practice.

I refer to: Reinventing the Bazaar: a natural history of markets, by John McMillan, W. W. Norton, 2006, which was spotted by Jed Chistiansen, whose blog, Mercury’s Blog: Mercury Research and Consulting blog (read it at:

Jed Christiansen writes:

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.”

And he offers some quotes from John McMillan’s ‘Reinventing the Bazaar: a natural history of markets’, of which I quote two:

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.”

Jed Christiansen writes that ‘Reinventing the Market’: “it lays a fantastic foundation for why prediction markets are such incredible mechanisms for forecasting and revealing information.” I am not sure what a ‘prediction market’ is, so I cannot comment, but I am skeptical about anybody in the ‘prediction’ business. If anybody could predict how a market was going to operate, she would end up with all the money in the world, or a large slice of it. Those that do make anything remotely like that sort of money, on occasion, or regularly, are gamblers, albeit well informed, and in a zero-sum business. If everybody wins, the game's over; if you win and nobody else does, somebody either ‘loses’ or ‘pays’ for your winnings.

Bargaining is different. Both parties win something that is important to them, from trading something that is of lower value. The proposition behind predicting markets is (remember, I am surmising from two words and without yet having read Reinventing Markets – I shall order it today from Amazon) the implied proposition that the outcome of prediction is more gainful than being unable to predict outcomes in markets. But I shall (and should) wait until I know more. Prices are signals about possibilities, not predictions of certainties. Markets invite responders to signals to act, to follow the signal. The outcome remains uncertain. A rising price for oil may signal that investment in oil exploration or production or stockpiling, may be profitable; it may signal 'get out of the oil business' and into substitutes. The appropiate outcome depends on what is done or not done; it is not 'predicted'.

I choose to ignore John McMillan’s sentence that includes: ‘we can rely on Adam Smith’s invisible hand to work’, on grounds that my arguments against such allusions are well known to readers of Lost legacy and I shall abstain from repeating them on this occasion (see archives).

My other concern is this sentence from the book: “A market’s design, supporting these features, may evolve from below or be imposed from above; usually there is a bit of both.” I am not sure about ‘designing’ markets – a design implies intention –and markets are not the product of a design (even a human design, let alone a deity's); they evolved by trial and error, workability and redundancy, more like water finding its own level than the putting together of cardinal elements. They are still evolving; every system of interference, usually from ‘above’ but common from ‘below' too from the participants (of which Smith wrote extensively in Wealth of Nations – the nefarious ‘merchants and manufacturers’, to which we can add also, the occasional consumer engaged in some fraud or other).

Markets are not something created long ago, which remain intact like a mechanical contrivance, an object or such like. There is a history of markets, but no archeology of them. They are what happens when people behave in a certain way – you can get markets forming in anything, anywhere, including cyber space – that exist and dissolve and re-appear, and the participants disperse and re-assemble, and move on. They work better when they are free, and the five conditions identified by Jed Christiansen operate; but even with one or more elements not present or deformed in some way, markets can still be operating at lower levels of efficiency, and still be better than central direction and control for all the reasons Jed has noticed and John McMillan, the author of Reinventing Markets, has written about in detail.

Even in totalitarian Soviet Russia, in the midst of the draconian controlled economy, ‘markets’ re-appeared like shoots on a rubble site, with illegal bartering among its local agents, supplying and demanding spare resources from each other just to keep the planning system functioning, despite the draconian penalties for doing so.

Markets are a human creation, irrepressible, resolute and pervasive. They will always exist, either open and free, or underground and repressed, as long as humans exist. As Smith put it, if it was necessary for Perfect Liberty to exist before human progress from barbarism to opulence could occur, there never would have been any progress.

The reason why is that markets as a human creation (not a ‘design’), even less than perfect (an impossible goal), and are better than whatever a ‘planner’ on an average day can do. Planners don’t have many ‘good days’ because they need tyrannical means to get their lumbering designed structures underway, and humans sooner or later dispel the notion that they can be moved around like wooden chess pieces (Moral Sentiments).


Blogger Haris H. said...

A prediction market is essentially a market where people wager on some event. For example, people can put money on a Republican or a Democrat to be the next president. The money wagered is thus closely tied to the probability of the event happening.

5:27 pm  
Blogger Gavin Kennedy said...

Thanks for the information. I have ordered 'Reinventing the Bazaar today'.

As I suspected, a 'prediction market' is about predictions based on probabilities, a sophisticated gamble, with a likely outcome.

I look forward to reading the case, but my scepticism stands - 'predictions' are not certainties, and the best economists can do is explain the past. Assumtions about the future are just that: fallible.

8:20 pm  
Blogger Jed Christiansen said...

Hello, Gavin. This is Jed Christiansen, and I just found this post that mentioned mine!

I hope you've had a chance to read 'Reinventing the Bazaar' at this point, and that you've come to the same conclusion that it's an excellent book.

'haris' was correct in that Prediction Markets aren't about predicting markets, but instead about using markets to make predictions. They're not billed as a perfect solution, just as a solution that's better than anything else for a large group of forecasting problems.

When I talk to companies about markets, it come down to this: would you rather have a battle of 5-10 personalities around a conference table make a major decision based on their individually-incomplete information, or would you rather have tens to thousands of people interacting in a market where their individually-incomplete information is combined and effectively cancelled out?

Prediction markets can be quite accurate; in research I conducted last summer, events given a 5% chance of occurring did in fact occur nearly exactly 1 in 20 times. An outside observer might say (for example) "the market was wrong, the 50% chance horse didn't win, the 2% chance horse did." But if the 50% chance event happened 50% of the time and the 2% chance event happened 2% of the time, I'd say the market was effective.

11:41 pm  

Post a Comment

<< Home