Thursday, April 8, 2010

Encouraging Arbitrage in Virtual Economies

I'm always surprised by how different companies conduct interviews - I shouldn't be after being surprised so many times; so my surprise at being surprised is surprising (to be all meta). Today I had to give a talk to a group of devs on the topic of Anything. I started out with snippets of my canned talks and then it diverged as people asked questions. Anyway, it is a virtual goods company so here is the talk I should have given, but the idea didn't hit me until I was in the car on the way home.

Encouraging Arbitrage in Virtual Economies

Wikipedia defines arbitrage as

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.

So arbitrage is being the classic and much maligned middle-man: buy from one guy and then resell to another guy at a slightly higher price. People hate middle-men because they seem to make money from doing nothing (they don't make anything dammit!), but they serve the very useful function of smoothing out prices. In return for their cut they add information to the system and more information is a good thing.

When there are a lot of people arbitraging a good you get more stables prices. When there are several pawnshops close by you can bet that they will charge very similar prices. You can walk into one and sell your iPod without doing research and be pretty sure you got a fair price.

When there is competition the gap between what you get paid for that iPod and the price of buying one also shrinks. This has huge ramifications because it basically allows you to rent items by buying them and then selling them back. Need an ebook reader for the weekend? buy it today and sell it back on Monday for $10 less.

What this means for virtual economies

In a heavily arbitraged market users can try out new things cheaply: instead of renting that ebook reader they can try out a FarmVille tractor or that fancy new Vorpal blade, safe in the knowledge that they can sell it back at a small loss. Users like to do new things, so this is good. Since arbitrage adds information to the system it also tells users what they should be doing. They can see through prices what other users value and then do more of that.

Note that I added some big qualifiers in there: heavily arbitraged, competition, a lot of people. To get those things you need to make arbitrage as easy as possible. You need a market that supports both "bid" and "ask" prices so the gap is obvious even to casual users. You also want as many people doing hard-core arbitrage as possible so give them as much information on past prices as possible in a very easy to use format. I really can't emphasize that enough: I've ruined many in-game economies by actively removing information from the system by say, buying up all the copies of an item. Other people didn't have any current information on the prices, and the games didn't offer historical information so it was only me who had it. This is possible even on sites that offer some historical information (Duels only listed the last N sales so I just sold to myself a bunch of times to clear the buffer).

If you have a bunch of people doing this and the transactions only happen in-game you also have a ready made money sink. Tax the transactions at X% and put the proceeds in /dev/null. An interesting question is what that tax rate should be. If it is high you get less arbitrage because there is no money to be made, and as a knock on the other users get less benefit because the cost of "renting" an item is higher.

PS, on a python-related note: there are lots of python folks that care about this stuff in real life markets too. Corner Hettinger or Glyph sometime when you have a few hours to spare.


Jack Diederich said...

I should add a note about real life automated trading. A valid complaint is that they can add _bad_ information to the system. When all their trading strategies are similar a feedback loop can happen and all the computers bid each other into a death spiral (it's nice to know that computers can get "tulip mania" too).

Some cool people are working on this problem by democritizing the technology by writing open source trading platforms. Basically the old saw "the answer to bad speech is more speech" approach.

Anonymous said...

I'm interested in this topic in the real world. But didn't get the "Corner Hettinger or Glyph sometime when you have a few hours to spare".
Could you please clarify?

Anonymous said...

Anonymous: Google is your friend.