How fighting for a prize knocks down its value
‘If many people have patience to queue for scarce (and underpriced) tickets, the value on offer will be consumed by the race to grab it’
I was recently told about an airstrip near a banknote-printing facility. Every day, planes take off, bursting with cash. It used to be that if you stood in a certain field near the airstrip, you could catch the dollars as they drifted gently to the ground, or scoop armfuls of them up from the soil. On average, $1m a day fluttered down.
Word soon got around. Before long, the field was packed with bill-catchers, racing and shoulder-charging each other to get the cash. People started to bring butterfly nets. The skies were thick with quadcopters darting around to snatch the money at altitude.
If you’re wondering where this field might be, don’t. It exists only in the imagination of Stanford economist Mike Ostrovsky, reported in Al Roth’s book Who Gets What and Why. But if the field did exist, you’d have to be a hardy soul to venture there. If $1m a day was known to be at stake, the ferocious quadcopter scramble would escalate until it cost almost $1m a day to run. If it didn’t, then people would have a strong incentive to keep buying drones until it did.
Economists call such arms races the “dissipation of economic rents”. They’re frustrating, because value is being frittered away in the competition to secure them. Think of the queue around the block for scarce (and evidently underpriced) concert tickets or the riots over cheap merchandise that occasionally break out during discount sales. If a few people are particularly patient, or muscular, or skilled at piloting drones, then they will keep at least some of the value; if many people have similar patience, strength or skill then the entire value on offer will be consumed by the race to grab it.
(The airfield tussle is particularly wasteful because real resources are being devoted to grabbing banknotes that could easily and cheaply be replaced. But even if the planes were dropping something valuable, such as saffron or USB drives, the process would mean that value was wasted.)
Another example is the business of high-frequency trading in financial markets, in which algorithms try to outwit or outpace each other as they scramble for trades in a contest that is over in less than an eye-blink. Some traders have invested in microwave networks, which are faster than fibre optics, to gain edges of less than a thousandth of a second as they respond in New York to news from Chicago. The parallel with the money-field is clear enough — and, unlike the field, high-frequency traders do exist.
A microwave link to save a few microseconds is in much the same category as a faster dollar-grabbing drone, or turning up earlier for a better place in the queue at an Oxford Street store. There is a value to having a liquid market for financial assets, one in which you can quickly find some buyers to compete for whatever you might be selling. But high-frequency trading adds little to market liquidity in times of crisis; the microwave link, like the drone, adds no value to society as a whole.
Can anything be done about such rent-dissipating behaviour? One approach is to tax it. We could levy a fee on standing in queues, or on microwave transmitters, or on stock market transactions themselves. If people who queue for scarce concert tickets are all taxed $5 an hour while they queue, then the lines will be shorter. The cost of the tax should roughly be offset by the reduced waiting time, so the queueing crowd is no worse off; the government, on the other hand, has acquired revenue from nowhere. This is a rare free lunch.
Taxing transactions is also a possibility, although a more problematic one. Much of the difficulty comes not from transactions themselves but from “quote stuffing”, where high-frequency traders make and withdraw thousands of bids, probing for information without actually making transactions. And charging for quote-stuffing might not help either. Three Canadian researchers (Katya Malinova, Andreas Park and Ryan Riordan) studied the impact of a regulatory change where traders were charged for quotes, not just trades; they found that quote volume fell sharply. But the bid-ask spread, a measure of market inefficiency, rose nearly 10 per cent. And while a transaction tax or quote tax would discourage some forms of high-frequency trading, it seems to me that the incentive to build microwave links between Chicago and New York would still exist.
So an alternative is to redesign the market to make it work better. In the case of queues for tickets, charging more for the original tickets would help, and the seller could hold an auction to set the perfect price. Financial markets could also be improved by introducing an auction once a second, batching together all the offers that have been submitted during that second. That would be fast enough for any reasonable purpose — and would remove the need to spend all this money on microwave relays.
Auctions are no more of a panacea than markets themselves, but they can help. Markets do not always organise themselves. A well-designed auction can mean less effort wasted in the fight to get to the front of the queue.
Written for and first published at ft.com.