August 24, 2010

No doubt Black and Scholes (1) are mentioned more often in business schools than Abraham. It's a pity though. The ancestor shared by all the religions of the Book has a thing or two to teach us about market theory which does not depend on some irrational belief in efficient markets.

Told by God of His plan to punish Sodom, Abraham remonstrates a just judge does not "sweep away the innocent with the guilty". Abraham further suggests taking the number of innocents caught in the process as a price to pay and proceed to bargain God down to the lowest possible price. Fearless, dogged, exasperating, he starts at fifty, tries out forty-five then forty, grows bolder with offers of thirty then twenty and settles for ten.

Notice how far advanced Genesis was in applying pattern recognition to the policing of people. Not only it admitted the existence of false positives, the innocents caught in the sweep, but it put a positive price on each victim and accepted the principle that, above a certain threshold, it became too costly to punish the guilty. Today's surveillance experts would rather follow Herod's more radical approach and assign zero cost to false positives.

The main lesson however is that, when two parties contemplate an economic transaction, price is an outcome, not a given. Rather each party assigns a value to the deal and an agreement should be reached whenever the buyer happens to put a higher value on it that the seller. Anywhere between these two extremes, the final price only reflects the relative negotiating abilities of the two parties to split the intrinsic added value of the transaction.

Another way to model this situation is to say each party predetermines a price range within which an agreement is possible. For each party, one bound represents the value, the other the starting price of the haggling session. This highlights a practical weakness. Starting points are public but values must remain secret lest a party set and keep one's price to the other party's value and hence pocket the whole added value. Yet without this hidden information the parties cannot know for sure whether an agreement is possible and may stare themselves out of a mutually beneficial deal.

Abraham's bargain illustrates another issue. If the other party happens to accept your starting price, a wider negotiating range would have led you to a better deal. If you dare, boldly reset your starting price, although five resets in a row is sure to exhaust the other party's patience, if not divine.

Given these problems, western price markets are much more efficient as long as they stay liquid. The price is still an outcome but a collective one, bypassing the need for face to face haggles. The same model enables producers to use market research to come up with the fixed, public price at which to sell their goods and services. Today middle eastern bargaining is mainly reserved for used car lots and national and international politics.

Such a linear view of history is unfortunately too complacent. Reality unfolds along an helix. Western price markets after all are based on a number of tacit agreements, the commoditizing of transactions especially, which our Information Age is busily tearing apart.

Read Virginia Heffernan's confession (*). "Member of Amazon Prime", she has come to believe "[this] canny move may have marked me as a fish at the Internet poker table". Why? Because nothing prevents Amazon to simultaneously offer what she deems a bargain to someone else at a lower price. Not that she has found proof positive Amazon practices differential pricing today but, as Professor Joseph Turow so aptly puts it, "the flow of data about us is so surreptitious and so complex that we won't even know when price discrimination starts".

Welcome back to middle eastern markets! What's wrong with that? In fact making price a variable is the first step in decreasing its overbearing preeminence. It might be excessive to think with Yochai Benkler that price taints any transaction it touches, but better accounting for all other variables on what I call value markets would be a welcome improvement. Doesn't personalization prime commoditization?

History of course does not circle back on itself. With modern technology, value markets are much more efficient today than in biblical times as long as two conditions are observed. The transaction must not solely exchange a fungible commodity and the market must be managed on a level field.

There lies the catch. Without eprivacy to protect participants from their counterparts and their competitors, but also from the market organizers, such as Amazon and the other personal data aggregators, no level field is possible . Indeed such market organizers are today in a favorable position to extract most of the difference in value between buyers and sellers for themselves by auctioning buyer access to sellers.

When it comes to our privacy, we tend to think like Adam Savage. According to Kate Murphy, he "posted a picture on Twitter of his automobile parked in front of his house" (**). Sure he forgot "to disable the [geotag] function on his iPhone" and thus told the whole world where he lived, but so what? "I'm not nearly as famous enough to be stalked". Though if he lived in Mexico, the land of virtual kidnappings, would he be so sanguine?

He simply forgets that, in negotiations, better information is power and power ultimately is converted into money. If "with its Places feature, [...] [Facebook] users can broadcast their location to the web, track their friends' movements and see who else has checked in a specific location", as reports David Gelles (***), the net effect will be to share away even more private data with Facebook itself. Reread its so-called privacy policy.

Mark Zuckerberg merely copies Foursquare. For the future, he may follow Shopkick Inc. which Jeffrey Chester, head of the Center for Digital Democracy, told Stephanie Clifford knows "where you are, what you buy, your spending habits, passions, excesses" as you let its "new smartphone application [...] track [...] shoppers as they move from outside the store, to counters, to cash registers - even inside the dressing room."(****).

Imagine yourself negotiating with someone who knows so much about you. You might as well surrender, which you do without realizing it and not to God the Most Benevolent but to a self-interested recommender. Forget differential pricing. A data aggregator worth its salt only needs to present you the suggestions which yield the highest margins according to your personal profile. Whether the recommender actually fulfills the transaction or simply the contact click is secondary. Google-like auctions use competitive pressure to redirect sellers' margins to the advertising network.

Intringuingly enough even price markets dealing in commodities are showing signs of returning to middle eastern practices. "Computers are programmed to pump out price messages", i.e. haggle under another name, rather than execute transactions. To account for it would require to set "a fee per message, not per trade" as "Ted Kaufman, a Democrat Senator from Delaware" suggests to the SEC according to Gillian Tett (*****).

In a pronaocracy though, many law makers will rank market fairness and stability below the need to finance their reelection campaign. Still, as Scott Turow recalls, "[Wanda Brandstetter]'s offer of $1,000 [to an Illinois state representative] lead [sic] directly to her conviction for bribery" (******). But if law forbids participants to document their bids, let alone their transactions, it ruins the efficiency of the law maker market. Ironical, isn't?

Will it ever change? Eventually but, as always while bargaining in the Middle East, you have no other option than waiting an indeterminate time.

Philippe Coueignoux

• (*) ........... Prime Suspect, by Virginia Heffernan (New York Times Magazine) - August 8, 2010
• (**) ......... Web Photos That Reveal Secrets, Like Where You Live, by Kate Murphy (New York Times) - August 12, 2010
• (***) ....... Facebook's Places feature adds to privacy concerns, by David Gelles (Financial Times) - August 20, 2010
• (****) ..... Aisle by Aisle, an App That Pushes Bargains, by Stephanie Clifford (New York Times) - August 17, 2010
• (*****) ... Debate on the structure of the equity market is long overdue, by Gillian Tett (Financial Times) - August 20, 2010
• (******) . Blagojevich and Legal Bribery, by Scott Turow (New York Times) - August 18, 2010
• (1) for more details, read about the Black-Scholes formula in the wikipedia