Prediction Markets

Predictions come in all shapes and sizes and in varying degrees of credibility. They include opinion polls, mathematical models of stock market behaviour and supernatural prophecies. Often predictions seem to be more a product of the particular climate at the moment. We have seen an example of this with this week’s global trends review published this by the National Intelligence Council (NIC). Just four years ago they proclaimed that there would be “continued US dominance…..most major powers have forsaken the idea of balancing the US”. Now they have become much more modest – “the multiplicity of influential actors and distrust of vast power means less room for the US to call the shots without the support of strong partnerships.” The world sure has changed a lot in 48 months

            One of the most fascinating developments in foretelling the future are the so-called “prediction markets”. Wikipedia defines them like this: “Prediction markets are speculative markets created for the purpose of making predictions. Assets are created whose final cash value is tied to a particular event (e.g., will the next US president be a Republican) or parameter (e.g., total sales next quarter). The current market prices can then be interpreted as predictions of the probability of the event or the expected value of the parameter.” How do they work? The idea is that the bits of information held by different individuals are aggregated into a market price. For it to work it is important that the participants make independent decisions. It would not work if they formed a committee to debate the question and reach a consensus decision. When people are together they interact in different ways and you can get a kind of groupthink, where the desire for consensus means that ideas are not sufficiently tested and contrarian opinions are just not heard. Prediction markets are  based on something called the “wisdom of crowds. The results tend to be more accurate than those of the individuals in the group and often more accurate than even the experts. This may seem like a crazy idea but prediction markets have two important things going for them. If you call someone up asking them for an opinion the person has no incentive to admit that he doesn’t know anything. Neither does he have a reason to tell the truth. By introducing money into the equation you are able to change these incentives. If you don’t know you have an incentive to shut up; if you are wrong you will lose money. 

These markets have been around for a number of years now. One of the most famous is the Iowa Electronic Markets which has been predicting presidential elections since 1988. The IEM is a real-money, web-based futures market. Traders can invest as little as $5 or as much as $500 to buy futures contracts based on the outcome of  elections. These traders could hardly be described as a representative sample of likely voters; the vast majority are  male, well-educated, high income and young. What makes the IEM such an accurate forecaster then? The answer is clear; traders are thinking differently about elections and politics than those taking part in opinion polls. They are putting their money on the line, creating a strong incentive for them to think critically. Their bets will reflect who they think other people would like to win and not their own personal preferences. The IEM is not alone. If you look on the web you can find other places such as Hubdub, where you can bet on news events and the Hollywood Stock Exchange, which specialises in movie box-office takings.

Some kinds of prediction markets have proved to be particularly controversial because off the incentives they create. In July 2003, the U.S. Department of Defence launched a Policy Analysis Market, to analyse events in the Middle East, including the probability of terrorist attacks. The knee-jerk condemnation did not take long to appear. Democrat Ron Wyden was forthright in his condemnation: “The idea of a federal betting parlor on atrocities and terrorism is ridiculous and it’s grotesque.”  The very next day the programme was cancelled. This may have been a mistake. Before the 9/11 attack there was lots of valuable and relevant information available but there was no mechanism capable of aggregating all that dispersed information in a single place. Markets may well be the best tool to achieve this goal. Obviously there would have been some difficulties in its functioning. One that springs to mind is that if these markets produced warnings, then the U.S. might take preventative action thus making the traders’ predictions false.

I realize that now may not be the best time to be defending the use of markets. Nevertheless, I feel that prediction markets have an important role to a play in our complex world. They can be a very useful policy tool in areas such as the introduction of new products by companies and military and political intelligence. The people in charge in governments and firms rely on information that filters through hierarchies; they can make better decisions with such markets. The benefits in terms of improved planning for future contingencies are clear. Robin D. Hanson, an economist at George Mason University has even proposed what he calls a “futarchy,” a form of government enhanced by prediction markets. Voters would decide broad political goals, but betting in speculative markets would determine the policy steps to achieve those goals. I don’t know if we will go that far but if I may be bold enough to make a prediction of my own, I think we are going to hear a lot more about prediction markets in the near future.

 

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