Deus Ex Macchiato

This idea comes from Doug’s comment to my last post. First, what is a Schelling Point?

From Wikipedia (mildly edited):

Tomorrow you have to meet a stranger in New York City. Absent any means of communication between you, where and when do you meet them? This type of problem is known as a coordination game; any place in the city at any time tomorrow is an equilibrium solution.

Schelling asked a group of students this question, and found the most common answer was “noon at (the information booth at) Grand Central Station.” There is nothing that makes “Grand Central Station” a location with a higher payoff (you could just as easily meet someone at a bar, or in the public library reading room), but its tradition as a meeting place raises its salience, and therefore makes it a natural “focal point.”

The crucial thing then is that Schelling points are arbitrary but (somewhat) effective equillibrium points. (For an interesting TED talk on Schelling points, try here.)

Schelling won the Nobel prize in Economics in part for the Points which bear his name. But what do they have to do with prices?

Well, in a sense a price is Schelling point. Two people need to agree on it in order to trade. There is no particular reason that BofA stock at $7.25 is a better price than $5 or $10; sure, stock analysts may well disagree, but I am willing to bet that few of them could get to $7.25 for BofA based on publically available information excluding prices.

As Doug says, this is even more the case for an illiquid financial asset. Here there are few prior prices to inform the decision as to what solution to propose to the Schelling coordination problem. A proper appreciation of the arbitary nature of the problem is required here.

Note, by the way, that I called a price a modified Schelling point. This is because, unlike a typically Schelling problem, you often know the solution that others have picked because you can often see the prior prices at which assets have traded. After all, the Schelling problem for strangers meeting in New York is a lot easier if you know the most common answer is ‘Grand Central Station at noon’.

I like the way that the metaphor of price-as-Schelling points emphasises the arbitrary nature of prices. Another good thing about it is that it highlights that buyer and seller together construct the equilibrium. If we say the answer is PDT at 9pm, then it is. Besides, PDT serves Benton’s old fashioneds, which are apparently things of genius, so this solution has particular merit. Note that I can make this solution more plausible by publishing maps of PDT, linking to positive reviews, etc. – think of this as the equivalent of equity research. I make my solution better known so that there is more chance that you will pick it too.

Posted in: Decision Making, Information Fusion, Markets, Mathematics and Science by David /