Wednesday, September 21, 2005

Useless Markets

A market is useless if it provides no incentive for its participants to operate in an efficient manner. Consider the "sports player" markets that Tyler Cowen just blogged about:
ProTrade, which opened for business yesterday, will treat professional athletes like stocks to be bought and sold, initially in a theoretical currency. Cash prizes will be awarded to the most successful investors.
Real stock markets work (sort of) because people expect stocks to have actual payouts correlated to some aspect of the actual company, namely profit. Stocks have a fundamental value, the present discounted value of expected dividends. People are induced to try to figure out what that value is (or the distribution of expected values) and trade the stock to that level. Real income is made or lost based on it.

But stocks in made-up exchanges like the Hollywood Stock Exchange don't have any sort of incentive structure. Let's say you buy a share of "Johnny Depp." So what? The first problem is that you're not using real money so your incentive to find the truly valuable "stocks" is significantly reduced already. They do have cash prizes for those who make the highest "returns," but there is a bigger problem that makes this pointless. The bigger problem is that the value of each security is based entirely upon what you think you can sell it for in the future. That is, if a security has value it is because of a rational expectations bubble. There is no fundamental reason why "Johnny Depp" should be worth more than "Keanu Reeves."

Useful are the new weather derivatives markets. Betting on weather seems a little silly, but if you are heavily invested in Florida oranges you can place bets against a hurricane in that area. Betting on two events that are correlated in an exactly negative way reduces risk without reducing reward.


Blogger Jason Kuznicki said...

This sounds just like the Blogshares market in weblogs. Probably not worth your trouble to look up, since it is, after all, useless.

10:03 PM  

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