prior probability

Hello, fellow nerds! I posed the following key question in my previous blog post: How likely is it that the price of any given belief contract on my truth market will eventually converge on the truth value of the conspiracy theory or fake news story being bet on? I will respond to this query by reviewing an influential paper titled “The use of knowledge in society” by F. A. Hayek (pictured below), the classic work that inspired me to propose “truth markets” to begin with.

Hayek’s paper, which was published in the September 1945 issue of the American Economic Review (AER), has seven parts. In Part 1, Hayek poses the following research question: “What is the problem we wish to solve when we try to construct a rational economic order?” (Hayek 1945, p. 519.) But why is constructing a “rational economic order” a problem in the first place? Because our knowledge about supply and demand is often fragmentary and dispersed among many different economic actors, or in the immortal works of Hayek:

“The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus **** a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge not given to anyone in its totality.” (Ibid., pp. 519-520.)

Hayek then identifies three major methods of knowledge organization in Part 2 of his paper: 1. central planning, e.g. a board consisting of experts; 2. markets or decentralized decision-making, and 3. monopoly, e.g. planning by a mega-firm like Google or Facebook. (Ibid., p. 521.) Which of these methods is the best? According to Hayek, the answer “depends on whether we are more likely to succeed in putting at the disposal of a single central authority all the knowledge which ought to be used but which is initially dispersed among many different individuals, or in conveying to the individuals such additional knowledge as they need in order to enable them to fit their plans in with those of others.” (Ibid.)

In Part III his paper, Hayek identifies two different kinds of knowledge: local knowledge (i.e. information that is “more likely to be at the disposal of particular individuals”) and scientific or technical knowledge (i.e. information “which we should with greater confidence expect to find in the possession of an authority made up of suitably chosen experts”). (Both quotes are in Hayek 1945, p. 521.) After making this distinction, Hayek emphasizes the importance of local knowledge:

“… a little reflection will show that there is beyond question a body of very important but unorganized knowledge which cannot possibly be called scientific in the sense of knowledge of general rules: the knowledge of the particular circumstances of time and place. It is with respect to this that practically every individual has some advantage over all others in that he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active coöperation.” (Ibid., pp. 521-522)

Hayek makes two further points about local knowledge in Parts 4 and 5 of his paper. First off, he emphasizes the temporal problem of change–how conditions can change rapidly or slowly over time, or in Hayek’s own words: “… the economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place …” (Ibid., p. 524.) Next (in Part 5), Hayek identifies a second-order problem about local knowledge: how is this knowledge transferred among the members of society. As Hayek notes, “… the ‘man on the spot’ cannot decide solely on the basis of his limited but intimate knowledge of the facts of his immediate surroundings. There still remains the problem of communicating to him such further information as he needs to fit his decisions into the whole pattern of changes of the larger economic system.” (Ibid., pp. 524-525, emphasis added. In addition, Hayek identifies a third-order problem: “How much knowledge does he [the ‘man on the spot’] need to [make decisions] successfully?” Ibid., p. 525, emphasis added.)

Hayek then devotes the last half of his paper answering these key questions. According to Hayek, the movement of prices determined via decentralized markets–what Hayek calls “the price system”–conveys the optimal amount of knowledge to the right people at the right time. Because Hayek’s explanation of the price mechanism is so crucial–not just to our understanding of economics but to other domains of life as well–I will review the second half of Hayek’s 1945 paper in my next post.

I recently proposed the creation of a “truth market” to allow people to buy and sell “belief contracts“; i.e. to place bets on conspiracy theories and fake news. One practical problem a new market must overcome, however, is “transaction costs” or liquidity, i.e. how easy or difficult is it to make trades on that market? (See here or the chart below.) At a minimum, a market must have a sufficient number of willing buyers and sellers in order to work properly. Why? Because without enough traders, the prices of the assets being traded on the market won’t reflect the underlying value of those assets.

So, how could we increase the liquidity of my proposed truth market That is, how could we attract a sufficient number of people to participate in the market? Here, I will offer two possible methods for generating truth market liquidity. One is to simply extend the purview of an existing prediction market like Kalshi or PredictIt. Although my proposed truth market would involve “retrodiction” as opposed to prediction, there is no reason in principle why we couldn’t extend the scope of an existing prediction market to include conspiracy theories and fake news.

The other possible solution is pay-to-play: just pay people to participate on the truth market. Specifically, a pro-market charitable organization, such as the Charles Koch Foundation or a think tank like the Mercatus Center, might consider putting skin in the game by creating and subsidizing its own truth market. To attract bettors, instead of funding yet another ad hoc study or wasteful conference on fake news, democracy, and social media, etc., the sponsor organization could allocate a fixed number of fully-transferable cash-value tokens to people in exchange for participating in the market. Market participants could include students, academics, pundits, and members of the public–people from all walks of life. The more the merrier!

Whichever method is tested (why not try both?), another serious problem that my proposed truth market would have to overcome is what I call the “Keynesian beauty contest” objection. To the point: What guarantee do we have that the price of any given belief contract on my truth market will eventually converge on the truth value of the conspiracy theory or fake news story being bet on? I will address this objection in my next post.

Fifty-nine years ago (22 November 1963), President John F. Kennedy was assassinated in Dallas, Texas. Ten months later (September 1964), the Warren Commission concluded that President Kennedy was shot by Lee Harvey Oswald and that the assassin had acted entirely alone.

Do you believe the official lone gunman theory, or was there a conspiracy? What if there were a truth market in which people could place bets on this question? (For what it’s worth, I propose just such a solution here and here, and I will address some possible problems with my proposed truth market during the Thanksgiving break.)

According to this report in The Guardian (U.K.), the morality police in Qatar are confiscating rainbow-coloured hats worn by fans attending FIFA World Cup matches.

Pictured above are just a small sample of the many PSA messages I was bombarded with at the Fort Lauderdale International Airport while I was waiting to board my return flight home. Not pictured are the incessant and even more annoying airport-wide intercom announcements on human trafficking and other evils. Welcome to the Soviet Socialist Republic of Fort Lauderdale! Paternalism is alive and well at the FLL airport.

(SEA stands for the Southern Economics Association.) This was the most insane conference I have ever attended. To the point, the conference program was printed in a tiny 10-point font (see, for example, page 137 of the program pictured below) and ran to 200-plus pages, and the morning panels began at 7:45 in the morning, with over 30 concurrent panels to choose from in each session! My main complaint, however, is that the economists of SEA refuse to apply market principles to their own conference. They charge a flat fee to attend the massive three-day conference (like a socialist version of Disneyland) instead of offering a la carte pricing, where one pays for the number of panels one actually attends (like a capitalist state fair, where one must pay for each ride). Memo to the SEA: do better!

I will be leading a panel on “New Perspectives on Adam Smith” at the annual meeting of the Southern Economic Association later today. Thus far, my favorite talk has been Henry Thompson’s on “The Organization of Extortion”, which explores the law and economics of criminal protection rackets. Alas, Professor Thompson’s extortion paper is not yet posted to SSRN, so in the meantime, here is his previous work on “Cosa Nostra Courts“.