Risk Markets And Politics

Tuesday, July 05, 2005

Potential

Mancur Olson in The Logic of Collective Action of 1965 describes the surprising advantage that special interest groups have in being small. The idea, later expanded by Gary Becker, is that members of relatively small groups are intensely vocal in promoting their interests over the concerns of larger "potential groups", which tend to remain silent. This is due both to the relatively small share in the total loss that each member feels, and to the difficulty and costs of organization in large groups. Imagine an industry with ten members lobbying for a government subsidy of 10 million dollars. Obviously their interest in the manner is much larger than that of those who implicitly bear the cost: the millions of tax-payers who will hardly notice the difference. Olson argued that even if the difference were tangible for the taxpayers, the sheer size of the potential group prohibits its formation. Even without taking organizational costs into account, the marginal reward in joining the anti-lobby for the first member is nil. (I am taking the interest to be the essence of the group, so there can be a group with no members if people share a common interest but are not yet organized.) Can we go further than Olson? Well, we should since TLoCA was written in 1965 and subsequent technology has made group organization exponentially easier, but this is just the first step. To me, the crucial leap is to create a group structure where the marginal incentive to join is greatest for the first participant, or at least tends to favor early participants. Where would this be the case? Precisely in an online market, not too unlike Tradesports, where the special interest could hedge the outcome of legislation for or against it.

What I am saying requires many qualifications and explanations. In the future I believe new types of markets will emerge that will allow individuals and groups to hedge risks, including legislative risks. The "potential group" is the group of what I previously described here as "speculators." What I have called "hedgers" corresponds to Olson's special interest groups which lobby as a "bi-product" of some other activity. The problem for Olson was that the potential group would remain latent because of insufficient incentives to form. In my scenario, the market imbalance caused by the special interest's initial desire to hedge produces an inefficiency in market price, which represents the probability of the legislation being passed by a certain date. Whether the price is interpreted as mean belief or something else does not concern me; the point is that the special interest's relative need to hedge will skew the market price and create an inefficiency for the speculator to take advantage of. The first speculator is the first member of the "potential" group. The marginal reward to join for the first speculator tends to be maximal. I will get to technical objections like market liquidity later-on, but if you are still following you might saying, "hold-on, your 'potential' group members (the speculators who take the other side of the special interest's hedge) stand to gain from the special interest getting its way in the legislature -- this isn't what Olson had in mind at all." I think it is actually, but I want to stress an important difference. The legislation-hedge market makes the outcome of the legislation non-binary. Instead of 10 million dollars going from the taxpayers to industry X, if the industry hedged by selling at 50% probability, then both the hedger and the speculators will end-up with 5 million. The special interest isn't forced into an all-or-nothing outcome and the market will simultaneously allow people to hedge their implied tax losses by betting with the special interest hedger, against the passage of legislation otherwise favorable to the hedger. Now, notice how the goverment's ability to (re)-distribute money has changed. This will obviously attract many people on the Right from the formal standpoint of the relationship between free enterprise and government, but simultaneously the Left stands to gain content-wise, as with stem cell research funding.

I'll compile objections and answer them in subsequent posts. How the government reacts to such markets is of course one of the more significant and interesting problems here.

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