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 / First Quarter 2000 / Issue 18(originally published by Booz & Company)


To Hal Varian, the Price Is Always Right

Intriguingly, one of Varian's favorite examples of how auction-flavored market mechanisms can transform a more traditional market was launched the year before the Santa Fe competition. Back in June 1988, several Iowa academics introduced the "Iowa Presidential Market" to trade shares in the candidates for the 1988 Presidential election. Instead of conducting polls seeking statistically significant feedback about which candidate would win, the I.P.M. insisted that its traders put up or shut up. People literally bid for the right to "vote" for their candidates.

"Marketizing" the poll utterly transformed its accuracy. "On the eve of the election, it forecast a vote share for Bush of 53.2 percent, which was exactly right, and a share for Dukakis of 45.2 percent, which was only 0.2 percentage points less than the share he actually received. This is substantially better performance than any of the opinion polls," explains Varian.

When this auction market was created out of something that was once a forum for freely expressed opinions, market forces made the poll more accurate. Why? Because of a very obvious phenomenon, says Mr. Varian: professional traders. Ordinary traders - that is, people who were biased toward Mr. Bush or Mr. Dukakis - bid differently for shares than those traders who actually wanted to make money. As Mr. Varian notes, "If their candidate's price got too high, they would sell him in a minute!"

The bottom line was the bottom line: Markets lure professional investors who believe their dispassionate analysis will yield greater returns on their investments. Indeed, says Mr. Varian, this has proven to be the case, as the original Iowa Presidential Market has evolved into the Iowa Electronic Markets, which currently run markets on a range of political events as well as on derivative securities on technology stocks.

And when markets scale up in size and opportunity, they attract a different kind of investor. It's inevitable that such investors will soon be drawn to all manner of Internet-enabled markets. Right now, there is a huge gap between the time, thought and investment that goes into bidding on an eBay or item versus, say, on cellular telephone licenses, oil drilling licenses or Impressionist paintings. "But that gap will narrow," Mr. Varian predicts. "Internet auction markets will become far more sophisticated. You'll be able to buy the counterparts of derivatives and stock portfolios. We're going to be seeing 'quants' come into auction markets. You'll see smart software agents bidding against smart humans and market participants won't be able to tell one from the other."

"Who's really threatened by this?" I ask. He half-jokes. "I claim Las Vegas." Humor about extraordinary popular delusions and the madness of crowds aside, Mr. Varian believes the Internet does, in fact, represent a fundamental discontinuity in how society creates and manages economic value. He unhesitatingly compares the Internet Revolution to the Industrial Revolution. However, where other pundits emphasize the distinctions between an era powered by coal and a period driven by silicon, Mr. Varian sees common patterns of innovation.

"During the American Industrial Revolution," he says, "the big idea was standardized parts. You had the ability to tinker with something and then, because the parts were standardized, you could make lots of those somethings pretty fast and cheap. So where are we at now? Standardized parts: the Internet, CGI scripts, TCP/IP, Javascript. The Internet is filled with innovations built with standard parts that get globally scaled because of what the Internet is. We're putting them together in different ways. We have people putting things together in garages and basements. It's craft; it's art; it's experimentation. It's doing a lot of crazy things and seeing what works. That's the right kind of innovation model for where we are right now, but it won't persist forever."

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