Are free markets in information flows good for stability?

Chris Dillow has an interesting post where he compares the role played by information cascades in triggering off stock market sell-offs and riots. In this context, in a recent paper Klaus Adam and Albert Marcet show that even a very small information cascade can generate significant asset price volatility. Can the same model of information cascades be extended to explain rioting?

Extending the same logic to social and political systems, there could be a strong argument that the latest communication technologies and information dissemination channels, which remove information market frictions, reduce their stability. In the circumstances, a familiar debate, similar to that between advocates of laissez faire and those favoring a more nuanced acceptance of free-markets, appears inevitable.

Laissez faire advocates would welcome the proliferation of these technologies as contributing to increasing the efficiency of information flows. They would argue that it will help people make more informed decisions and thereby reduce distortions and prejudices that are commonplace in social, political and economic markets. Is this assessment correct? Is unrestricted information flows and social networking platforms an unqualified good? Do market failures in financial and economic systems carry any relevance for information markets?

There are a few observations on this.

1. Information markets are vulnerable to atleast some of the same failures that characterize financial markets. Mere availability of information does not guarantee efficiency in decision making. As is the case with financial markets, thanks to the cognitive biases of human beings, the manner in which the information is presented or made available has important bearing on their individual response.

2. Social and economic systems straddle a fine line between stability and chaos. Unrestricted information flows often end up unsettling the delicate balance in such systems and chaos ensues. Without going into the merits of whether the delicate balance was sub-optimal or inefficient, it is often the case that stability is the casualty when the information market is unshackled. This assumes importance since socio-political stability is critical for any economic growth and development. The instability that followed the break up of countries like Yugoslavia is an example of this.

3. This brings us to an issue of whether some form of information latency is desirable for social and political stability. For example, in a highly heterogeneous society, democracy and the formal norms of democratic governance cannot be readily transplanted without having in place several other institutionalized checks and balances. Conventional norms of majority rule can be destabilizing in these countries, as evidenced by the civil wars in the aftermath of democratic elections held in a few African countries in the nineties.

4. As information flows unhindered and the communication channels become more active, the probability of even small events upsetting the balance is greater. Even small, often insignificant information flows, as the work of Klaus Adam and Albert Marcet shows, have the potential to generate considerable instability. A sharp increase in the quantity and velocity of information flows, as is happening now, significantly increases the probability of such dynamics being triggered off. This increases the social or political riskiness associated with traditionally unstable societies. This also means that instability mitigating institutional systems assume much greater significance in these countries.

5. Always-on and many-to-many communication channels like social networking sites amplifies the impact of free information flows. In all respects, these channels are much more disruptive of stability that mere information flows. Further, their stability creating aspects, most often end up being crowded out by the stability disrupting aspect. After all, do we not more often come across examples of an information flood clarifying issues instead of complicating them?

None of this is an argument in favor of placing restrictions on information flows and social networking sites. Far from it. It is only a note of caution and a pointer to possible triggers that can upset the stability of social, political and economic systems. It therefore becomes important that such information technology developments be accompanied by policies that mitigate the market failures that arise out of them.

The Groupon effect - using social networks to address collective action problems

In recent months, the electronic coupon company, Groupon, has revolutionized the way the internet can be harnessed to minimize search and co-ordination costs (the collective action problem) in retailing. Its electronic discount coupons get activated (discount sales happen) only if a certain number of fellow citizens agree to buy the same thing on the same day. The retailer makes up his loss due to lower price with larger number of customers, who not only bring in larger immediate sales but more importantly brings in future patronage.

Groupon subscribers receive notifications of one deal a day, tailored to their location and profile. The local business gets customers, and Groupon takes a share of the coupon proceeds. The average Groupon deal offers 50 to 90 percent off retail goods and services, from restaurant certificates to skydiving lessons. Once the tipping point in registrations is reached, all buyers are locked in, and their investment becomes irrevocable. If the point is not reached, the deal is automatically aborted.

Groupon's spectacular success (it has been described the fastest growing internet company ever and has already crossed 50 million subscribers) since its founding in 2008 by Andrew Mason has naturally generated considerable commercial interest. Attempts by all the major web-service providers, including Yahoo and Google, to take-over Groupon have been rebuffed. The company recently raised a record $950 million from big investors and is considering a $15 bn IPO soon.

For its part, Groupon harnesses the power of psychology to attract customers and retailers. It seeks to leverage the inherent attractiveness of a shopping plan where customers are forced to wait for sometime to find out whether they can win the deal. The one-deal a day strategy also means that the attention bandwidth of customers can be more easily captured.

This psychological attraction of getting deep discounts also means that Groupon like websites are likely to become extremely popular in price-snesitive markets like India. In order to overcome the challenge posed by the limited reach of computers and internet, it may be more effective to use the now ubiquituous mobile phones to deliver such shopping deals in these countries. Further, mobile phones offers the possibility of much greater interactivity, potential for behavioural nudges, and the achievement of more overall efficient outcomes.

A recent article in NYT, in the context of the recent wave of street protests that have swept Middle East and North Africa, speculates on the possibility of solving the collective action problem with street protests. It writes, "Even if we all watch television coverage of demonstrations together and express our enthusiasm for the movement online, we have no guarantee our neighbors will take the physical risk of going out in the streets until they actually do so".

Technology will make it much easier for frustrated societies to express their collective anger. However, I am inclined to believe that translating this collective angst into tangible action on the field will remain beyond the reach of technology (apart from increasing the likelihood of participation) and as much a challenge as ever.

Update 1 (20/4/2011)

Excellent infographic on the rise of Groupon.

Update 2 (5/5/2011)

Felix Salmon identifies the USP of Groupon - the idea that coupons only become activated once a certain minimum number of people have signed up for them. He writes,

"This is essentially a guarantee for the merchant that the needle will be moved, that their effort won’t be wasted. With traditional advertising or even with old-fashioned coupons, a merchant never has any guarantee that they will be noticed or make any difference. But with a Groupon, you know that hundreds of people will be so enticed by your offer that they’re willing to pay real money to access it. That kind of guaranteed engagement is hugely valuable, and more or less unprecedented in the world of marketing and advertising."

Update 3 (5/11/2011)

Groupon debuted in the equity markets 31% higher than its offer price in its first trading day, bringing the online coupon-seller’s valuation to more than $16bn and reflecting a surge of excitement for one of the fastest-growing and most controversial companies to list in recent years. Shares in the company were set at $20 late on Thursday, then jumped as high as $31.14 in the first few minutes of trading before closing at $26.11. Groupon raised $700m in its highly anticipated initial public offering, in a deal which valued the company at $12.6bn, higher than the anticipated cap of $11bn but below the $20bn the company had sought earlier this year.

The company’s co-founders, who own about a third of the company’s shares, became billionaires. Andrew Mason, chief executive, has a stake worth about $1.2bn. Groupon’s buyers included many funds that intended to “flip” the shares to take advantage of their first-day jump. By the close, 49m shares had changed hands, nearly the entire float, making it the second most traded US stock on the day.

An ode to cities!

I am waiting to read Edward Glaeser's new book. Till then, via Freakonomics, a few snippets

1. The density of cities generate network effects - "Being near smart people matters". Enrico Moretti has found that people’s wages typically rise by about 8 percent as the share of their fellow urbanites with college degrees goes up by 10 percentage points. He writes,

"I find that a percentage point increase in the supply of college graduates raises high school drop-outs’ wages by 1.9%, high school graduates’ wages by 1.6%, and college graduates wages by 0.4%. The effect is larger for less educated groups, as predicted by a conventional demand and supply model. But even for college graduates, an increase in the supply of college graduates increases wages."

Further, "globalization and new technologies have increased the returns to being smart, and we get smart by being around other smart people".

2. Educated cities grow faster and can better adapt to economic declines. Edward Glaeser and Albert Saiz write,

"Educated cities have grown more quickly than comparable cities with less human capital... We also find that skilled cities are growing because they are becoming more economically productive (relative to less skilled cities), not because these cities are becoming more attractive places to live. Most surprisingly, we find evidence suggesting that the skills-city growth connection occurs mainly in declining areas and occurs in large part because skilled cities are better at adapting to economic shocks."

A good school system that harnesses the urban advantages of competition and innovation adds to the strength of cities.

3. Cities with large numbers of smaller firms have become innovation hubs and have tended to create more jobs. Edward Glaeser, William Kerr, and Giacomo Ponzetto have written,

"Employment growth is strongly predicted by smaller average establishment size, both across cities and across industries within cities, but there is little consensus on why this relationship exists. Traditional economic explanations emphasize factors that reduce entry costs or raise entrepreneurial returns, thereby increasing net returns and attracting entrepreneurs. A second class of theories hypothesizes that some places are endowed with a greater supply of entrepreneurship. Evidence on sales per worker does not support the higher returns for entrepreneurship rationale. Our evidence suggests that entrepreneurship is higher when fixed costs are lower and when there are more entrepreneurial people."

4. Successful cities keep atrtracting migrants. One pre-requisite to keeping the flow of migrants going is to have affordable housing. As cities grow, vacant spaces get exhausted. In the circumstances, the only way for cities to keep housing affordable is to keep building vertically. As Ed Glaeser writes, "Chicago’s sea of cranes on Lake Michigan helps explain why average condo prices in the New York area are more than 50 percent more than condo prices in the Chicago area."

5. Densified and vertically growing cities are more environment friendly than suburban sprawl. Building up is also an environmentally sensitive alternative to building out. Edward Glaeser writes,

"People who live in cities do tend to emit significantly less carbon than people who live in the country... That’s coming mainly from driving, from the fact that there’s just a lot fewer carbon emissions associated with dense living. It’s not just the move to public transportation; it’s also the drivers within cities — they’re just driving much shorter distances. And then, of course, it’s because of much smaller homes. The higher price of urban space means that people are living in smaller homes, even with the same family size. And that leads to lower electricity usage, lower home heating usage — and those are the facts that I think make cities seem, at least to my eyes, significantly greener."

See this excellent article on skyscrapers.

Update 1 (8/3/2011)

A person’s earnings rise by more than 7 percent as the share of people in his or her metropolitan area with a college degree increases by 10 percent, holding that person’s own level of education constant. Educated neighbors are particularly valuable in dense cities, where contact is more common. Edward Glaeser writes,

"Before the industrial revolution, cities were centers of small, smart companies that connected with each other and the outside world. Small companies and smart people are the sources of urban success today. The industrial city now seems like an unfortunate detour during which cities exploited economies of scale but lost the interactive exchange of ideas that is their most important asset...

A great paradox of our age is that despite the declining cost of connecting across space, more people are clustering together in cities. The explanation of that strange fact is that globalization and technological change have increased the returns on being smart, and humans get smart by being around other smart people. Dense, smart cities like Seattle succeed by attracting smart people who educate and employ one another."