Political prediction markets

While I was attending college, one of my economics professors would semi-regularly base part of his class discussions off of prediction markets. A prediction market is, most simply, a financial market that is based upon whether events occur in a specified manner. According to Wikipedia:


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. Prediction markets are thus structured as betting exchanges, without any risk for the bookmaker.
Other names for prediction markets include predictive markets, information markets, decision markets, idea futures, event derivatives and virtual markets.
People who buy low and sell high are rewarded for improving the market prediction, while those who buy high and sell low are punished for degrading the market prediction. Evidence so far suggests that prediction markets are at least as accurate as other institutions predicting the same events with a similar pool of participants.


(Prediction Markets, 8/7/08)


Prediction markets are extremely useful as an informational tool. Take for example, a small market (10 people) of investors betting on whether a stock will rise. The combined knowledge of those investors is necessarily larger than the information held by any one, but can it really be very accurate? The marketplace, the millions of parties that transact on a daily basis to form an ultimate outcome, will necessarily have a better idea of what is likely to happen than can a small group of investors, however smart each one may be.


What happens if we take the same investment opportunity - whether a stock rises - and open up a market? Anyone who wants is then entitled to make a short or long purchase of the stock, essentially betting on whether the price will go up or down. With many thousands, and often millions, of investors betting on whether a future event occurs, and with each of their decisions contributing to a final price, we have a prediction-machine with more knowledge than any one, one-hundred, or one-thousand of those investors could know individually.


The beauty of this is that the profit-motivation that each individual feels is transformed into a relatively reliable prediction-mechanism. Governments, firms, and individuals can then assess the situation based upon what the prediction market is saying will happen, and alter course accordingly.


There are prediction markets for the outcome of presidential races, not just stock performance. Right now, I've got roughly $500 riding on whether one of the American candidates wins the election. Now, because the futures on this market are liquid (i.e., they are futures, not forwards), I can sell anytime I want. Each security price is expressed as a number out of 100, for cents on the dollar. So, if the market says my candidate's chances are 10% better than when I purchased the futures, my net worth increases ten cents on the dollar. I am free to trade out for money if I am contented with this modest increase, or, if I feel really sure my candidate will win, I can wait until the election. If my candidate then wins, the future expires, and I either get $1 per purchase, or nothing. I think it's pretty darned cool. I'll either have a much better or a much worse opinion of my gamble come November.


A good friend and fraternity brother of mine in college took exactly the opposite position, rather forcefully. He saw this as gambling, and not just on the outcome of a pair of dice, but on our nation's political future. He thought that America's future was too serious a thing to toy with in what is essentially a political casino and that any prediction markets based off of the results of a presidential election were immoral and irrational. I can see his point, to a degree, but I'd make the couterargument that whether the largest companies in the country turn a profit might have a bigger impact, in practical terms, on our lives than the results of a presidential election. Seeing as how active prediction markets operate for the economy as a whole, I see no problem with "gambling," or as I like to call it, increasing the accuracy of the future-predicting machine.


Go to intrade.com if you want to try some of this out for yourselves.