The Nobel Prize

Today the Nobel Prize in economics was presented to Paul Milgrom and Robert Wilson who developed auction theory and auction design. The Nobel Prize site provides an excellent background for understanding their work. Interestingly, this includes a differentiation between the common value of a good and the private value as a key feature. Where the definition of a private value is defined as one achieved when the bid decision is made independently of any other bidder in the auction.

The 1996 Laureate in Economic Sciences, William Vickrey, established auction theory in the early 1960s. He analysed a special case, in which the bidders only have private values for the good or service being auctioned off. This means that the bidders’ values are entirely independent of each other. For instance, this could be a charity auction for dinner with a celebrity (say a Nobel Laureate). How much you are willing to pay for such a dinner is subjective – your own valuation is not affected by how other bidders value the dinner. So how should you bid in this type of auction? You should not bid more than the dinner is worth to you. But should you bid lower, perhaps getting the dinner at a lower price?

The explanation goes on to describe the theory of common value.

Entirely private values are an extreme case. Most auction objects – such as securities, property and extraction rights – have a considerable common value, meaning that part of the value is equal to all potential bidders. In practice, bidders also have different amounts of private information about the object’s properties.

The portion of the bid that is devoted to the common value is based on a projection of what the bidder feels others will pay. Thus to have better knowledge is advantageous. Here the familiar diamond trader example if used.

Let’s take a concrete example. Imagine that you are a diamond dealer and that you – as well as some other dealers – are contemplating a bid on a raw diamond, so you can produce cut diamonds and sell them on. Your willingness to pay only depends on the resale value of the cut diamonds which, in turn, depends on their number and quality. Different dealers have different opinions about this common value, depending on their expertise, experience and the time they have had to examine the diamond. You could assess the value better if you had access to the estimates of all the other bidders, but each bidder prefers to keep their information secret.

Now if the diamond traders are from a tight knit community, say of the Jewish faith, than all those in the faith are included in the advantageous bidding environment. The information is public information within the group, private to those at the exterior. This type of diamond trader group is used by sociologist James S. Coleman in his famous treatise from 1988, Social Capital in the Creation of Human Capital.

Wholesale diamond markets exhibit a property that to an outsider is
remarkable. In the process of negotiating a sale, a merchant will hand
over to another merchant a bag of stones for the latter to examine in
private at his leisure, with no formal insurance that the latter will not
substitute one or more inferior stones or a paste replica. The merchandise
may be worth thousands, or hundreds of thousands, of dollars. Such free
exchange of stones for inspection is important to the functioning of this
market. In its absence, the market would operate in a much more cumbersome, much less efficient fashion.

Coleman stresses the benefits of assurances. Assurance which can be given due to the greater knowledge of the stones, their quality and source of origin. Coleman says:

Observation of the wholesale diamond market indicates that these close
ties, through family, community, and religious affiliation, provide the
insurance that is necessary to facilitate the transactions in the market. If
any member of this community defected through substituting other stones
or through stealing stones in his temporary possession, he would lose
family, religious, and community ties

Coleman concludes that there is value in this. He’s view is that the value lies in the social ties, or the social network, which parties to the transaction are able to access.

Another more recent use of the Jewish diamond traders appears in a paper by Barack D. Richmond, How Community Institutions Create Economic Advantage: Jewish Diamond Merchants in New York. In this case the value retained by the group are derived from an ability to enforce contracts. Here’s an excerpt from the paper, bolding is mine:

The particularly interesting feature of this system is the economic role
of ultra-Orthodox Jews. The ultra-Orthodox provide critical value-added
How Community Institutions Create Economic Advantage 415
services that add significant efficiency to the system of exchange. They work
as skilled diamond cutters whose polishing increases the sale prices of stones,
and they play the essential role of middlemen brokers who match certain
stones with the buyers who most value them. Their unique credibility provides
the Jewish merchants with a comparative advantage over rival merchant groups
that lack such community foundations, and their role identifies limitations
to public contract enforcement that persist even in developed economies.

When courts fail, community institutions can arise to fill their place.

Here’s what we know from these three uses of the Jewish diamond traders example. All three feel the group has created some type of value—not to anyone individual but a blanket of value across the group. This value has something to do with how the group is connected, how the information flows through its membership. And that there is a commitment to maintain a standard of enforcement.

What is exciting about Milgrom and Wilson’s differentiation of private and common value is that there is a tie-in to price. An auction bring buyers and sellers into a marketplace. And the values that these two new Nobel Laureates observed reflect activity of a private nature and that of a common nature.

As pointed out in previous posts the categorizing of goods as either private or public (or club and common) is inadequate. My first post here introduces the idea that a haircut can have a public (common) component. And I also wrote a post about national defense as there are many examples of how this public good was used to the benefit (privately) of a sub-group. The long and the short of it is that goods are goods. It is how they are employed, by what types of groups, which determines the portion of their price derived from a private sphere and that derived from a public sphere.

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