Buy Me Out

Forbes.com
September 20, 2004

By Vernon L. Smith

When the public good is at stake, maybe it's better to be ruled by dollars than by votes. Suppose New York City proposes a zoning law change that would permit the construction of taller office buildings in one part of town. The neighbors, or others who see the change as hurting them, will turn out to vote "no" in a referendum on the issue. Those who stand to gain will turn out to vote "yes."

Whichever side commands a majority will enjoy a capital gain, while the other side will suffer a capital loss. Some existing properties will increase in value while others will decrease. Much money may have been spent on lobbying for or against the measure. Democracy at work. The majority imposes reduced wealth on the minority and votes more wealth for itself.

As noble as democracy is, it is excluded from most of the choices we make. We don't use majority rule to decide whether New York will build a Metropolitan Opera House, whether Yo-Yo Ma will play at Carnegie Hall or whether Volkswagen will discontinue the newest version of the Bug. If enough people are willing to pay to have an opera house, see Yo-Yo Ma or buy the Bug, those things happen. But in zoning, because the public good is at stake, people think the majority should hold sway.

Maybe there's a fairer way to divide the spoils--fairer and more practical, too. Together with George Mason University graduate students Ryan Oprea and Abel Winn, I've been running experiments to test an alternative approach using what we call a Referendum Center. We use real people and we pay real money, but we test hypothetical situations. Here's how we would approach the zoning dilemma.

Suppose those who think they will be hurt by the zoning change simply send to the Referendum Center a bonded bid stating how much they are willing to pay for the status quo. Those who think it's a good idea to loosen the rules and who see themselves as benefiting would send in bonded bids stating how much they are willing to pay for rule change.

So there are two piles of money bids. The biggest one, say $100 million, wins. The losing pile of bids was, let us say, $90 million. Each person who bid for the losing option receives a check for the amount that he or she bid. The money put up by the winning bidders is used to compensate the losers.

What if a losing bidder complains that his compensation is not high enough? We'd say it's his fault; he should have bid higher. But he must not bid more than the zoning change is truly worth to him because if he wins, he'll have to pay too much.

If he expects to win, his motivation is to bid less than the true worth to him, because everyone wants a bargain. But if he overplays this hand he will lose the bidding war. And then his compensation will be less than what he will lose in worth. In short, it's not easy to game the result. You have to put real money on the table.

Our solution is not ideal. But the bidding procedure is simple, fair and less coercive than majority rule, where the winners provide zero compensation for the damage they inflict on the downtrodden minority.

We're still examining a number of questions. Since more is bid by the winners than is needed to compensate the losers, what do you do with the surplus ($10 million in the example) after deducting the cost of conducting the referendum? Keep it as if it were a tax, or distribute it as a bonus to the losers?

We're also examining possible pitfalls. Suppose that lots of the people who bid for choice B actually prefer choice A. They think B will lose, and they hope to share in the payout to be funded by the choice A winners. Would this sort of speculation cause instability, even though there are incentives not to do this and to simply make a straightforward bid? In our experiments we find that the only subjects who do this are those who are assigned (randomly) very low values so that they have little to gain and also little to lose. These "dishonest" bids are therefore inconsequential because they are small and involve only those with little at stake. It's a behavioral issue that we learn about with experiments.

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