If everyone free-rides, free market may free-ride, too

A post at Marginal Revolution covered an interesting issue: http://www.marginalrevolution.com/marginalrevolution/2008/12/a-remarkable-qu.html

Here is a related question I have been thinking about the art market.

If people buy an artwork as a speculation, to sell later at a higher price, then they must be making the assumption that there will be people who ‘like’ the artwork.

But, if everyone thinks that way, that is they buy based on ‘other people’s preference’, how can the price be determined?

This seems similar to Keynesian beauty contest, in which entrants are asked to choose a set of six faces from photographs of women that were the "most beautiful" and those who picked the most popular face are then eligible for a prize. (source: http://en.wikipedia.org/wiki/Keynesian_beauty_contest)

My hypothesis is that the market will be unstable, prices swinging widly together. Because everyone is waiting for a signal that shows other people’s perception, a tiny fraction of people that moves before other people can influence the great majority. These early movers are buying based on their own aesthetic preference, unlike others. How few these independent buyers are, they are the total sample of the market and their influence can be huge.

Let’s say there is only 1 buyer who really likes a painting, and she is willing to pay $1000. Then the price that a speculative buyer would pay should not be higher than $1000. These are people who would not pay even $100 to buy the painting, without the speculative opportunity.

However, when there are a lot of speculative buyers, it does not seem to work like that. Speculative buyers guess what the price would be, based on their knowledge about people’s preference. Furthermore, it is also possible for some to try to ‘move’ the market.

Then, the voice of ‘real’ demand is mixed up with the voice of these ‘experts’. And the majority of free-riding speculators will put more weight on the experts’ opinion, because the experts represent the market, not just one buyer.

So, when things are good, they overshoot. And there is no ceiling in rising price. B hears from A that the price will go up, and tell C the same thing. C tells A that people are saying the price will go up. And it goes on. When there is few buyers buying for their own enjoying, this bubble grows itself.

When market turns pessimistic, things look opposite. When there is a real buyer, he could stop the decline of the price. He will buy when price has dropped sufficiently. But if there is no real, as opposed to speculative, buyer, there is no natural stopping of the fall. Only until the experts get bullish again.

The key difference between speculative buyers and real buyers is whether the price one is willing to pay is reasonably fixed or vary widly according to external influences. Not to make this post too long, my conclusion is that unless there are enough real buyers deciding independently the market will be very unstable.

There is another topic related to this, which I would like to write about later. That’s about ownership premium (or call it distributed ownership discount). I think distributed ownership of an asset or a business lowers the value of the asset. A company owned by many small % shareholders will be manages worse than one owned by a few large % shareholders, other things being equal.