How Valuable is Prime Minister's Dissolution Option?: Black-Scholes Approach to Parliamentary Dissolution

Abstract

When does the prime minister call election? This paper attempts to solve the puzzle by utilizing financial option pricing model developed in the field of financial economics. We construct an actor-based theoretical model that designs early dissolution as solution for the prime minister’s dynamic optimization problem. The prime minister seeks to exercise her right to dissolve her cabinet at the optimal timing, the timing that maximizes her chance of winning an election, until the end of her term. This is analogous to the choice that the owner of financial “call option” faces. The owner of call option seeks to exercise his call option at the optimal timing until the expiration date. In this paper, we first construct a modified financial option pricing model that fits to political situation, calculate values of the prime minister’s right to dissolve, and solve the dynamic optimization problem of the prime minister. Second, we deduce a theory-driven empirical model that serves as an alternative to the hazard model, a long-time standard empirical framework for research on this and related topics. Finally, we run simulations and find several theoretical as well as methodological insights. For example, compared to past empirical research that assumed rising/constant “duration dependence” with little theoretical explanations, results of our simulations show that “duration dependence” of early election has strong and complex theoretical foundations. Our simulations also show the volatility of the popularity of cabinet, whose significance has been overlooked in past research, has strong impact on determining timing of early elections.

Keywords: cabinet termination, cabinet dissolution, early election