Bastiat’s Bastions

James Glassman has this really insightful article on economic stimulus in the March issue (now online) of Commentary magazine (at commentarymagazine.com).  Readers of Bastiat’s Bastions will note that Mr. Glassman is also a fan of Bastiat and references the same story “What is seen and what is unseen,” that we have mentioned here repeatedly, starting with the first post here in January of 2006.

-MC

If you haven’t heard, the Cubbies have a pretty good team this year. They’ve clinched a birth to the playoffs, and are predicted to do some damage in the playoffs.

(Or wait – is that the fans that are predicted to do some damage? I’m getting ahead of myself.)

Read this article from the Chicago Sun-Times.

It seems some local political types are worried that, gasp, should the cubs win their first world series in 100 years (seriously, it would have been 100 years), that the numerous bars around Wrigley Field should stop serving beer after the 7th inning of any game in which they could clinch the series. They are worried about some unruly behavior.

The thought process is, that because the cubbies fan will stop drinking for an hour (beer will be served after the game ends), there will be less unruly behavior.

I find it a bit of a stretch…

We’ve talked about what happens to current demand when there is an increase in the expected future price of a product. Current demand increases when the price is expected to rise.

If the bar can’t sell you beers after the 7th inning, then you can think of the price becoming very very high after the 7th inning ends. As such, we’d expect a big spike in alcohol purchases just before the 7th inning.

But two more questions to consider. If people just buy an extra hour’s worth of beer before the 7th inning and drink at the normal pace, there is no effect of the regulation. A useless government intervention.

But could it be worse? Could people guzzle the last one, or guzzle the next one, or buy some Jaeger-bombs (they still taste ok warm), and become more unruly than they would have if there hadn’t been the ban? Could the rule induce substitution from beer to liquor?

Granted, there might be some people who just stop drinking for an hour.

However, the article says that policy is voluntary. How many bars do you think are going to volunteer to follow this policy?

Would you be in favor of this rule if you owned a bar near Wrigley? If you owned a bar just outisde of the covered area?

In the end, what does the rule accomplish?

Or does it really not matter at all because the cubs have no hope of clinching anything? Sadly, I worry about this option the most.

A hat tip to the folks over at sportseconomist.com for pointing out the article and writing a post similar in spirit.

–CT

A picture of the price of the Louisiana contract. The prices are the squares (right axis) and the bars are the volume (left axis). See the previous post for some details, but the basic idea is the price of the contract reflects the probability that the hurricane would make landfall in Louisiana and be at least category 2.

If we could find an enterprising student that would gather some data on how the “cone of error” evolved, it might be fun to put them together and so some analyzing.

If you click on the picture, a new window appears where the image is a bit more clear.

–CT

Update: I’ve added the picture for an identical contract on Hurricane Ike as of Monday night at 9:00 pm.

I should have purchased flood insurance in 2005. It turns out I made a bit of a mistake when purchasing my house.

Apparently I haven’t learned from my mistake. Maybe I should have purchased flood insurance this year. But I did not. Apparently, I like to live dangerously.

So can I run out and buy flood insurance tomorrow? I could, but there is a 30 day waiting period for the flood insurance policy to become active. If there were not such a provision, one would expect there to be many policies sold this week.

I am stuck bearing the risk of flooding myself. As such, I will be nervous for a couple of days. But enough about my worries.

The other day, Dr. Coats wrote on gambling markets predicting election outcomes. Between the two of us, we have written many times about prediction / gambling markets and the efficiency thereof. If you look over the left, you’ll see in the archives you can read all the post about prediction markets here. Nonetheless, one more post couldn’t hurt.

Guess what else is predicted by gambling markets. Anyone? Weather outcomes. Yes, that is right, you can bet on where Gustav will land.

Some people are going to get all upset – why would people want to bet on where a hurricane will land. It is immoral, rude, whatever. But there is at least one very good reason why these markets are very nice to have. And there others are I won’t even discuss.

But first, some of the background (again). Just as with the political markets, each contract will ultimately expire at a value of 0 or 100. If you purchase the Louisiana contract, and Gustav makes landfall first in Louisiana, and is at least a category 2 hurricane, your contract will be worth 100. If Gustav first makes landfall in some other state, or is not a category 2 hurricane, your contract will be worth 0. You can buy or sell these contracts at any time. You can also buy contracts for the other states that border the gulf, and even some states that don’t. (My Clemson pals are resting assured that the gambling market thinks it is very very unlikely that Gustav will first make landfall in South Carolina.)

Before I get to the market’s current predictions, I should note that currently, this market is what finance scholars like to call a “thin market”. There are not many buyers and sellers. The spread between the bid (what people are willing to pay to buy a contract) and the ask (the price at which people are willing to sell the contract) is quite large. Thus, it is difficult to give you a precise probability – trades are infrequent and the prices noisy. However, I’ll guess it will pick up in the next couple of days.

Nonetheless, at the time of my originally writing this post (3:30 AM on Thursday – which explains any remaining typos), the prices suggest the chances of landfall is:

Louisiana: 40%
Texas: 20%
Florida: 20%
Other: 10%
Less than Category 2: 10%

Click here for updated prices.

A couple of things of note:

If you are an all-star meteorologist, and have a better idea where the hurricane is going than the gambling market, you have a money-making opportunity. But just as Dr. Coats explained with political markets, my bet, pardon the expression, is that the gambling market will get it about right. Again, the caveat is that this is a thinly traded market.

As I mentioned above, some people won’t like this idea. In fact, some pretty smart people though it would be a good idea to set up prediction markets for terroristic events – Dr. Coats has written about this previously.

But one hugely desirable feature of these markets is they allow people to hedge their risk. If I bought a contract today, I can basically buy hurricane insurance, and do so with no waiting period. How?

I could, say, buy contracts that are worth, say $4000 based on the price of 40 today. If the Hurricane lands in Louisiana, while my house might be gone, each contract will have a price of 100, and thus my contracts are now worth $10,009. My gain on the contracts ($6000) would at least partially offset the losses on my house.

If, however, the hurricane peters out or ends up in Florida, my contracts are worth 0. I’ve paid $4000 for contracts that are not worth anything. But I would have gotten to sleep better.

So one last thing – Is the price of 40 (a 40% chance) appropriate?

Just for fun, I went to www.nola.com, and checked out the latest computer models of where the hurricane will go. There are 12 different computer models, and they all disagree to some extent. I have no clue which ones are a good model and which ones are a bad model. However, of the 11 that project far enough out see what state they’d land in, 6 of the 11 predict a Louisiana landfall. If I assume each model is equally good in predicting where the hurricane will go, this, it seems, predicts a probability of 0.545 that the hurricane lands in Louisiana. So you’d think the price of 40 is a good deal, right?

Not so fast. Keep in mind the contract requires landfall in Louisiana and the storm to be a category 2 or higher. If we think the probability that storm will be category is 0.9 (and the intensity of the storm is independent of where it makes landfall), then the probability the storm lands in Louisiana at category 2 or above is 0.545 * 0.9 = 0.50. We are getting pretty close to the neighborhood of what the gambling market says.

What will be interesting to see is how the price evolves as the storm gets into the gulf. If it weren’t for the thin market, we could say more.

My prediction? Bid ask spreads will narrow, and one or two states will see big increases, while the rest will see decreases. Stay tuned.

–CT

In the approaching U.S. Presidential election, there will be discussions about who is better equipped to lead the country for the next four years. Discussions will get heated and opponents demonized. Other discussions will turn to the horse race. Who is ahead? What is the extent of the lead? How can winners be predicted beyond the daily fluctuating and often conflicting polls that are constantly being reported?

Certainly, polls are used to forecast election outcomes, and are crucial in the process. But to see where the smart money is in an election, just look where the smart money is.

In commodities markets, the futures markets provide a best guess as to where the price will be in the future. Speculators abound. And, as I recently discussed (but also originally here at Bastiat’s Bastions), foolish market participants lose money and exit the market while those who are better at predicting are able to increase their market presence.

The market price in speculative markets is also the one that is at the middle of the pack, the price with as many dollars bet above the going price as below, making it a strong predictor.

Speculative markets can be best thought of as betting markets, like sports betting markets. Here is where we see the smart money in the market, where the center of the money being wagered by those who are confident enough with their predictions that they each “put his money where his mouth is.”

This argument is nicely made in a recent Slate.com article, where the markets are explained. Take a look at Intrade.com and at the University of Iowa’s “Iowa Electronic Market, the first election market, (a research and educational tool set up by faculty members at the University of Iowa), but also look at each prospectus in the Iowa markets. Two types of markets to look at are the vote share markets, where the betting is on who will get what share of the vote, kind of like betting in sports markets with point spreads, and the “winner-take-all” markets which simply bet on the winner. The market prices for the vote share markets, then, are predictors at how the shares of the popular vote will turn out, while the price in the “winner-take-all” market is the market prediction of the probability of Obama or McCain winning the election.

At the close of the Iowa Electronic Market on August 20^th, the prices in the vote share market stood at $0.511 for Obama and $0.499 for McCain. The redemption prices at the end of the election will be for Obama will $1.00 times the two-party vote share that Obama receives, and similarly for McCain shares. So, if a speculator thinks that Obama will garner more than 51.1% of the popular vote (among the two top parties), that speculator will be driven to buy shares of Obama, while those who think Obama will get less of the vote will be driven to sell shares.

In the winner-take-all market, the close-of-midnight prices on August 20th were $0.596 for Obama shares and $0.396 for McCain. If a speculator thinks that Obama has better than a 59.6% chance of receiving the most popular votes, that speculator has an incentive to buy shares of Obama in the winner-take-all market. If a speculator thinks McCain has better than a 39.6% chance of getting the most votes, that speculator has an incentive to buy McCain shares, but will have an incentive to sell if the speculator thinks McCain’s chances are lower.

There is a concept in economics called the “efficient markets hypothesis,” which only means that market prices embody all available information. One type of information that is crucial in these markets is the information provided by polls. Speculators in these election betting markets also use every bit of information available not only about which candidates are favored by voters but also about how driven potential voters are to actually make it to the polls to cast their ballots.

So, if you want to find out how your candidate is doing, look beyond the polls and the pundits to the betting markets, particularly those at intrade.com and at biz.uiowa.edu/iem. While no forecast is perfect, these markets have already proven to be better than the polls and television’s talking heads.

(Note: This article, written by Dr. Coats, was first published at BasilAndSpice.com on 8/23/08.)

-MC

In this Washington Post article, there is a discussion about how Sen. Obama plans to go after speculators, who he and his advisers see as destabilizing prices the prices of oil.

The only problem with this is that speculators are NOT destabilizing oil prices, and in fact, any intrusion into the futures markets and those where these supposedly evil speculators lurk, will most assuredly destabilize oil prices. We have to be sure about we do before rushing headlong to correct something that may not be broken. Public policy makers should follow the physician’s dictum, “Primum non nocere,” Latin for “first, do no harm,” instead of the politician’s dictum of “do anything, as long as it sounds good, no matter how much harm it might cause.”

First, recall our class discussion on the law of one price. If goods can be moved from one market to another rather costlessly, anytime goods are selling in two different markets at different prices, people will buy them up in the low-priced market and then resell them in the high-priced market. This is called “arbitrage”—buying in one market in order to resell in another. Arbitrage moves goods from lower valued uses to higher valued uses.

People who specialize in market speculation are risking their money on the movement of prices in the future. Essentially, speculators, then, bet on the direction of price movements. Speculators, then, are taking part in a special sort of arbitrage, moving goods from one time period to another. If speculators think that the prices will increase in the future, they buy up such goods now, driving prices up now, and then sell these goods in the future, adding to future supply and reducing prices in the future from what they would be otherwise. If they bet wrong, they lose, they end up buying when prices are higher and then selling the good when the price has fallen, again adding to future supply, but buying at thigh prices and selling at low prices. So, when speculators err, they lose funds and are in less of a position to speculate further.

Those who tend to be good at predicting future prices, then, stay in the market and live to speculate another day. Poor prophets make losses when they buy high and sell low, and so, soon exit the market, as they run out of either their own funds or backers. Poor prophets of future prices do destabilize markets, but they lose money and soon exit the market. Good prophets make profits and stick around the market. Futures markets come to be dominated by good prophets. They buy up in periods of low prices, when goods would otherwise be put to low valued uses (since the market is relatively flooded) and move them to times when they are valued more.

One of the best known stories of speculators is the story of Joseph and Pharaoh. This Joseph is the one from Broadway musical “Joseph and the Technicolor Dreamcoat,” that starred Donny Osmond. This is, of course, based on the story from the Old Testament, where Joseph, a son favored by his father, was the victim of sibling jealousy. As the story goes, his brothers threw him down a well and stained Joseph’s prized “coat of many colors” with pig’s blood in order to deceive their father about Joseph’s fate. Slave traders rescued Joseph from the well and sold him as a slave. He came into the Pharaoh’s employ, became an advisor to the Pharaoh, and ultimately Pharoah’s second in command.

You should recall from this story that Pharaoh began having troubling dreams about seven fat calves followed by seven frail calves and seven full ears of corn (what Europeans called grain and later called maize when they ventured into the New World) followed by seven dried out ears of corn. Pharaoh didn’t understand the meaning of his dream, but Joseph easily figured that in meant that there would be seven years of bountiful harvests followed by seven years of famine, and he shared the meaning with the Pharaoh. Joseph, being a good economist as well as a good prophet, advised the Pharaoh to speculate in the market for grain, buying it up during the years of bounty and storing it during the years of famine, when prices would be much higher. Not only did Joseph and Pharaoh make great sums of profits (from Joseph being a superior prophet), but they also saved lives of people and livestock far and wide. In fact, Joseph’s father, on hearing that Pharaoh had grain to sell, sent his sons to buy grain, where, of course, they found their brother.

Speculators, when they are good prophets, move resources from where they are plentiful to where they are dear. In addition, they stabilize prices, by adding to demand when prices are low, increasing prices, and by adding to supply when prices are high, bringing prices down. Good prophets do good things and make good profits. False prophets do bad things and they make losses for themselves and destabilize prices for others.

We should note that all oil producers are speculators by necessity. Oil producers can extract oil more rapidly or less rapidly. The more they extract from an oil well or from an oil formation now, the less will be available from that formation in the future. If oil producers think that prices will be higher in the future, their opportunity cost of extracting it today is higher and they will extract less oil today. The lower they expect oil prices to be in the future, the lower the cost of extracting that oil today. One result of this logic is that by opening up the Atlantic Coast, the Pacific Coast, the Florida Coast and ANWR to drilling and exploration, the lower prices will be in the future, reducing opportunity costs of extracting oil now and reducing prices immediately upon even hints of discoveries. Another result of this logic is an understanding of why oil companies are not extracting everything that they can now, and why they are preserving oil for the future, unlike what many in Congress want oil companies to do with those oil formations.

The question for Obama’s advisors is “if they are such good prophets and know more about what will happen with the prices of oil than current oil speculators, why is that they are not heavily investing in the futures market for oil, betting that prices will come down and “trading short” (look here in Wikipedia for a good explanation for trading “short”)? Who are the false prophets?

We have to look beyond today’s oil prices, today’s oil demand and today’s oil extraction costs. We need to think about future conditions of the world, especially future conditions in oil producing regions such as the Middle East and especially the Persian Gulf. What are the concerns there?

Well, one concern is our own presence in Afghanistan and Iraq. Is that stabilizing or destabilizing the region? In other words, what effect does our presence there have wars have on the region and on oil prices? What should cause everyone “pause” (the French word for “stop”) is the last remaining part of the Axis of Evil (because North Korea is being so good these days–sure), Iran, and its threats of nuclear devastation of Israel. The greater the threat of confrontation between Israel and Iran, the greater the chance of disruption of oil through the Persian Gulf, the higher the future price of oil and the higher the opportunity cost of extracting oil today.

The high price today guides us learn to conserve oil, guides us to explore more for oil, and guides us to look more for alternative energy sources. In addition, it preserves oil in the ground from being used today to drive one SUV so that it can be used in the future to drive fifteen Mini Coopers the same distance. In other words there really is something worse than high oil prices, and that is prices held artificially low, allowing frivolous current use of oil and then, running out in the future. High prices of depletable resources keep us from running out before we develop more sustainable alternatives.

Some see Obama as soft on Middle Eastern Terrorist and soft on the Iranians, especially when he suggests that he would sit down and talk with the President of Iran. If the likelihood of Obama becoming the next President of the United States is seen as encouraging the Iranians to take action against Israel, then it could even be possible that Obama’s very success could be destabilizing the price of oil. Of course, that is remote, but it is more likely than speculators being wrong about the chance of disastrous Middle Eastern conflict.

-MC

Late last night (Oct. 1, 2006), I couldn’t sleep and turned on cable news, “Fair and Balanced.” The twin talking heads, the “Beltway Boys,” were making their predictions on how many seats the Democrats would pick up in the House and in the Senate, and whether it would be enough to upset the current Republican majorities in those two chambers. They both thought the Democrats would fall short of winning the Senate, but were split over the House, with one saying they would fall short and the other saying the Dems would get the majority in the House.

One thing to remember about the talk of the talking heads is that Talk is Cheap. Talking heads don’t have that much to lose if they miss things a bit. So, I went to the tried and true method of predicting the outcome of those races, the electronic market at the University of Iowa. At www.biz.uiowa.edu/iem, you can see the results of a real live betting market on the House and the Senate. These markets work better than the polls on predicting the outcome of these races, because they use all information available, including the polls. At the Iowa Electronic Markets, the traders who think that the Dems will take over the House have an incentive to buy up contracts that have the Republicans losing the House. The market, then, weighs the opinions of those who think the Dems will win in proportion of the money bet on the Dems winning, and weigh the opinions of those who think the Reps will maintain their majority in the House in proportion to the money these people bet. The market, then, is a panel of experts who are willing to place bets on their projections, weighted by the money they are willing to bet.

These markets really work very similarly to the Double-Auction markets I demonstrate in my principles of economics classes. They also work very similarly to sports books and pari-mutuel betting (horse racing). Besides the Iowa Electronic Markets, Tradesports.com (http://www.tradesports.com/), a popular sports betting site, also often runs bets on such political events. In fact, if people start betting more on one horse, then the odds for that horse winning goes up. If the markets did not work this way, the odds makers would lose and be forced to pay out more than they take in.

Can anyone really know what will happen in these elections? Not really, at least not until the elections are over. Can we make better predictions than the polls? Here the answer is “yes.”

For a full explanation as to how the market works, go to the www.biz.uiowa.edu/iem site, or go to an article I wrote for the Bayou Business Review some years back at http://www.nicholls.edu/mcoats/newopeds/iowapoliticalmarket.htm.

A couple of years ago, Robin Hanson suggested the same type of betting market could be set up to predict terrorism events. You can read Hanson’s paper, “Designing Real Terrorism Futures,” at http://cipp.gmu.edu/news/PE-of-Terror.htm (I presented my own paper with Robert Tollison of Clemson and Gohkan Karahan of NSU at that conference). Hanson’s idea is that markets are good ways to combine information from many sources, such as the CIA and the FBI, because as we know, these agencies tend not to share information.

Hanson’s “terrorism futures market” never got off the ground. Even though we know that one of the problems that left us vulnerable to the attacks on 9/11 was that the CIA and FBI don’t communicate, and worse still, information sometimes gets squashed in the bureaucracy. Hanson’s market would have given people in the know, the FBI and CIA operatives, an incentive to commincate their information in a simple, easy to understand number, a price. Politicians who didn’t bother to read the proposal got up in arms at the notion of a market for terrorism and squashed the idea before it could even get a fair hearing.

By the way, if you go to the Iowa Electronic Market, you will see that the Beltway Boys weren’t that far off.

MC

Michael Sokolove writes an interesting article in the New York Times Magazine titled “From Pastime to Nap Time” on the effect that drug testing will have on Major League Baseball. This is not your tired article on steroids that points out that Mark McGwire is four dress sizes smaller since he left baseball. This article addresses how testing for amphetamines will change the game.

The claim is that the practice of taking amphetamines (”greenies”) to deal with the rigors of the daily grind of a 162 game schedule was widespread. MLB’s new improved drug testing policy includes testing for amphetamines. Therefore, testing will reduce the use of greenies and change the way the game is played. Let us make some assumptions…

(1) Players are able to play a higher level of play when taking amphetamines.
(2) Some players are taking amphetamines.
(3) Day games following night games are particularly difficult, and therefore the time where amphetamine use is expected to be highest.
(4) The testing process causes (some players) to stop taking amphetamines

A result of effective testing would be to reduce amphetamine use. Thus, we would expect…

(1) A fall off in the level of play to occur as the overall level of concentration or energy would be lower.
(2) The fall off in level of play will be largest for day games following night games.

Interesting in its own right, but there is more economics tucked away later in the article. Sokolove includes a quote from Billy Sample, a former player, who gives us some gambling advice. Hold your horses before calling your bookie (or go to the track instead). Here is an excerpt from the article that quotes Sample…

Billy Sample, who played nine seasons in the big leagues before retiring in 1986, believes the most difficult challenge in the post-greenies universe will be those pesky day games after night games. He says, “People who bet on the over-under line” — a wager on how many total runs will be scored — “they should probably take the under on those games.”

An over/under bet is fairly simple. Bookmakers determine a number of runs, called the “over/under line”, that they think will be the number of runs scored in a game by both teams combined. If the line is 7, and you bet the “under,” you are betting that fewer than 7 total runs will be scored. If you bet the “over,” you are betting that more than 7 runs will be scored. Bookmakers try to get the line “right” – so that half of betters wish to bet the over, and half wish to bet the under. Without getting into the details, the bookie takes a cut of winning bets, and as a result can earn money even with equal numbers of people betting the over and under. In fact by doing so, he earns money without taking any risk.

Sample’s argument is that everyone will be too tired to swing a bat during those pesky day games, fewer runs will be scored in these games, thus making the under bet more desirable. Sample may be right about the runs scored. (He is assuming that greenies affect hitting more than pitching and defense.) However, even if there are fewer runs scored in these games, you still should not run out and bet the under and expect to win more than half the time. Why?

Begin for a second by making the dubious assumption that bookmakers do not realize the effect of the amphetamines ban. They set the over/under at 7, thinking this is the correct line. However, suppose some “informed” bettors realize the “true” line should be less than 7. They would see a profit opportunity, as betting the under would win more than half of the time, perhaps often enough to pay the bookie’s commission and still come out ahead. The large bets being placed by informed betters on the under will result in more money being bet on the under than the over. Bookies are sure to notice this imbalance and try to induce more betting on the over. How? By lowering the over/ under line. How far will the line have to adjust before the betters are evenly distributed? Until the line is set at the “correct” level. The point is, eventually, the market settles on the correct line.

If this sounds like the story you heard in your microeconomics class about “excess quantity demanded” and how prices adjust to equilibrium, it should. You can think of the betting lines as prices.

As economists, we believe gambling markets (and financial markets in general) are wonderful aggregators of information. Related is the idea we call “market efficiency.” A person that has superior information will indeed find profit opportunities. These profit opportunities provide incentives for many people to seek out superior information. People finding this information and acting on this information (a bunch of people betting on the under in our case) causes the information to be transmitted to markets. As economists, we say that all publically available information is quickly “priced into the market.”

While profit opportunities may occur for short periods, they disappear quickly. You cannot consistently “beat” the gambling market (or the stock market), unless you have truly “insider information” (information not publically available), and lots of it.

Do not think that bookies are slouches. They are in the information business, and it pays for bookies to adjust the lines quickly. Those who do not quickly adjust soon find they are paying off a lot of bets and may end up selling furniture before too long.

While Billy’s story might be right, this information is publically available and is already priced into the market. If Billy was the only one who knew this, he should not have had this information printed by the New York Times! Rest assured, if you bet the under every time a day games follows a night game this season, you will win about 50% of the time.

Epilogue:

An enterprising student could collect the lines and the time of days of games to see if lines for day games following night games were, on average, lower than other day games for past seasons. In fact, if amphetamines were important, and testing is effective, we should see this gap increase for this coming season.

Also, I once went to a Cubs game with my sister. She told me during the game that she was rooting, not for the Cubs, nor the hated Cardinals, but instead for the pitchers! I thought she was a moron. Now I wonder if she had money on the under!

A hat tip to the folks over at The Sports Economist for pointing out the article.

–CT