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Optimal Electoral Timing: Exercise Wisely and You May Live Longer

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Author Info

  • Jussi Keppo

    (IOE Department, University of Michigan)

  • Lones Smith

    (Economics Department, University of Michigan)

  • Dmitry Davydov

    (Equities Division, Goldman Sachs)

Abstract

In many democratic countries, the timing of elections is flexible. We explore this potentially valuable option using insights from option pricing in finance. The paper offers three main contributions on this problem. First, we derive a rationally-based mean-reverting political support process for the parties, assuming that politically heterogeneous voters continuously learn over time about evolving party fortunes. We solve for the long-run density for this process and derive the polling process from it by adding polling noise. Second, we explore optimal timing using the political support process. The incumbent sees its poll support, and must call an election within five years of the last election to maximize its expected total time in office. This resembles the optimal exercise rule for an American financial option. This option is recursive, and the waiting and stopping values subtly interact. We prove the existence of the optimal exercise rule in this setting, and show that the expected longevity is a convex-thenconcave function of the political support. Our model is tractable enough that we can analytically derive how the exercise rule responds to parametric shifts. We calibrate our model to the Labour-Tory rivalry in the U.K., with polling data from 1943-2005 and the 16 elections after 1945. Excluding three elections essentially forced by weak governments, our maximizing story quite well explains when the elections were called, and beats simple linear regressions. We also measure the value of election options, finding that over the long run they should more than double the expected time in power of a fixed term electoral cycle.

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Bibliographic Info

Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1565.

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Length: 37 pages
Date of creation: May 2006
Date of revision:
Publication status: Published in Review of Economic Studies (2008), 75(2): 597-628
Handle: RePEc:cwl:cwldpp:1565

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Phone: (203) 432-3702
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Web page: http://cowles.econ.yale.edu/
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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

Related research

Keywords: American option; European option; Brownian motion; Electoral timing;

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References

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  1. Patrick Bolton & Christopher Harris, 1999. "Strategic Experimentation," Econometrica, Econometric Society, vol. 67(2), pages 349-374, March.
  2. Alvarez, Luis H. R. & Keppo, Jussi, 2002. "The impact of delivery lags on irreversible investment under uncertainty," European Journal of Operational Research, Elsevier, vol. 136(1), pages 173-180, January.
  3. Godfrey Keller & Sven Rady, 1998. "Optimal Experimentation in a Changing Environment," Game Theory and Information 9801001, EconWPA.
  4. André Blais & Elisabeth Gidengil & Neil Nevitte & Richard Nadeau, 2004. "Do (Some) Canadian Voters Punish a Prime Minister for Calling a Snap Election?," Political Studies, Political Studies Association, vol. 52, pages 307-323, 06.
  5. Cochrane, John H, 1996. "A Cross-Sectional Test of an Investment-Based Asset Pricing Model," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 572-621, June.
  6. Smith, L., 1997. "Time Consistent Optimal Stopping," Working papers 97-5, Massachusetts Institute of Technology (MIT), Department of Economics.
  7. Daniel Diermeier & Antonio Merlo, 1998. "Government Turnover in Parliamentary Democracies," Discussion Papers 1232, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  8. Philip H. Dybvig & Mark Loewenstein, 2003. "Employee Reload Options: Pricing, Hedging, and Optimal Exercise," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 145-171.
  9. John Y. Campbell & Samuel B. Thompson, 2005. "Predicting the Equity Premium Out of Sample: Can Anything Beat the Historical Average?," Harvard Institute of Economic Research Working Papers 2084, Harvard - Institute of Economic Research.
  10. Duan, Jin-Chuan & Simonato, Jean-Guy, 2001. "American option pricing under GARCH by a Markov chain approximation," Journal of Economic Dynamics and Control, Elsevier, vol. 25(11), pages 1689-1718, November.
  11. Feddersen, Timothy J & Pesendorfer, Wolfgang, 1996. "The Swing Voter's Curse," American Economic Review, American Economic Association, vol. 86(3), pages 408-24, June.
  12. Alastair Smith, 1996. "Endogenous Election Timing In Majoritarian Parliamentary Systems ," Economics and Politics, Wiley Blackwell, vol. 8(2), pages 85-110, 07.
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Cited by:
  1. Felix Bierbrauer & Lydia Mechtenberg, 2008. "Winners and Losers of Early Elections: On the Welfare Implications of Political Blockades and Early Elections," SFB 649 Discussion Papers SFB649DP2008-071, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.

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