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Blog : Penny Stocks, Game Theory and Numb3rs
by John Whitefoot on October 19th, 2007
Earlier this week Americans Leonid Hurwicz, Eric S. Makin and Roger B. Myerson won the Nobel Prize in Economics. And yes, I’m sure many think the Nobel Prize is an abstract honor awarded annually for something with no real-life application.
This year’s award is quite different, and may be of some interest to those who like to buy and sell things…oh…like stocks, or art, but that’s a different story.
The American trio won the Nobel Prize in Economics for developing a theory that helps explain how sellers and buyers can maximize their gains from a transaction. Something we’d all love to do.
Now, trying to read the trio's winning design theory on the inner working of financial markets is not as easy as you might think. While their mechanism design game theory may sound like an intangible hypothesis, you are probably more familiar with its inner workings than you think you are.
Game theory is a branch of applied mathematics that is often used in the context of economics. It studies strategic interactions between agents. In strategic games, agents (buyers and sellers) choose strategies which will maximize their return.
The essential feature is that it provides a formal modeling approach to social situations in which decision makers interact with others; like the stock market.
In addition to its academic interest, game theory has received attention in popular culture. A Nobel Prize–winning game theorist, John Nash, was the subject of the 2001 film A Beautiful Mind. The character Charlie Eppes on the television show Numb3rs often uses game theory to nab befuddled bad guys.
In its citation, the academy this week said that the work done by Hurwicz, Makin and Myerson has let us “distinguish situations in which markets work well from those in which they do not.
In a nut shell, the gap between buyers' and sellers' knowledge, and consequences for the efficient operation of a market or auction, is at the heart of this research.
For example, economic transactions take place in markets. Some markets are free of government intervention while others are regulated. The theory shows that so-called double auctions (where buyers and sellers post their bid- and ask-prices) can be efficient trading institutions when each trader has private information about his or her valuations of the goods traded (i.e. what you initially paid for the stock).
Essentially, if you are buying a stock, you think the share price is going up and you like the asking price. If you are selling a penny stock, you are saying you don’t think it is going to go up much further and you are happy with the bid price.
Sellers seek the highest sale price and buyers are seeking the lowest. Both parties have different levels of knowledge about the transactions value. The goal is to find the middle ground where you maximize your profits, or minimize your losses.
Maskin and Myerson’s design game theory was cited for determining what kind of auctions or selling procedures could bring in the most revenue for sellers. Unfortunately, buyers in an equity market are a fluid, unstructured mass, with a wide range of options to choose from. As a result, a buyer can never reasonably hope not to pay a premium for an acquisition of a market-traded equity. Good news if you’re selling your penny stock.
In an interview, Maskin said he received the unexpected call from the academy at his Princeton home – a house once occupied by physicist Albert Einstein. “There are so many people who could win,” Maskin said. “It’s like winning the lottery basically.”
But then again, as a game theorist, Maskin could have probably predicted with some degree of certainty his chances of winning.