Thursday, December 01, 2011

Price Coherence on Intrade

A couple of days ago, Richard Thaler tweeted this:
Intrade prices seem incoherent. How can Newt nomination price soar but Obama win stay at 50%?
Here's what Thaler is talking about. Over the past couple of weeks, the price of a contract that pays $10 in the event that Gingrich is nominated has risen sharply from about a dollar to above $3.50:

Over the same period a contract that pays $10 if Obama is reelected has remained within a narrow window, trading within a ten cent band a shade above $5:

Thaler considers this pattern to be incoherent because Gingrich is widely believed to be a weaker general election candidate than Romney. For instance, in head-to-head poll averages Obama currently leads Gingrich by 5.7%, but leads Romney by the much smaller margin of 1.5%.

But even if Gingrich really is the weaker candidate against Obama under any set of conditions that might prevail on election day, it does not follow (as a point of logic) that a rise in the Gingrich nomination price must be associated with a rise in the Obama reelection price. For instance, a belief among voters that Obama is more vulnerable would ordinarily result in a decline in his likelihood of reelection, but this could be offset if the same belief also leads to the nomination by the GOP of a more conservative but less electable candidate.

This reasoning is consistent with the so-called Buckley Rule, which urges a vote for the most conservative candidate who is also electable. As perceptions about the electability of the incumbent shift, so does the perceived viability of more ideologically extreme members of the opposition. These countervailing effects can dampen fluctuations in the electability of the incumbent. Hence the market data alone cannot decisively settle the question of price coherence.