Monday, May 14, 2007

Prediction Markets: when in Romania?

I cannot but agree with the main idea of the recent statement on the prediction markets (you can download the PDF free of charge via SSRN, once you make an account with them), signed by a bunch of top economists, including 4 Nobelists. Of course the request is fitted for the legal framework of the USA, but such a thing would not be unwelcome in any other country. Take Romania, for instance (I would be very much interested to know what is the legal framework relevant for this context, in there). I already suggested "Basescu Impeachment" contracts traded on such a market :-). An equally interesting one would be "Becali Prime Minister in the next decade": would you put your money on that? :-). These markets tend to be extremely good predictors of future outcomes, much more so than any polls. Here's the main idea of the prediction markets, very well emphasized within the statement linked above:

Prediction markets go by a number of different names, including information markets and event markets. An example will help clarify what we mean by a prediction market. Suppose a contract pays $1 only if candidate "X" wins the presidential election in 2008, and the market price of an X contract is currently 53 cents. That means the market "believes" X has a 53% chance of winning the election. This is a simple example of a binary outcome prediction market that was pioneered by professors at the University of Iowa in the late 1980s.

Prediction markets have already been used in a variety of contexts with remarkable success. For example, prices of economic derivatives predict economic variables better than professional economists; prices in Iowa political markets are typically more accurate than the polls in forecasting elections; and prediction markets at Hewlett-Packard Labs beat official forecasts of printer sales most of the time.

Prediction markets reflect an old thought that underlies the price system: Information is widely dispersed in society, and it is highly desirable to find a mechanism to collect and aggregate that information. These markets work for several reasons: First, almost anyone can participate. Second, people think hard when they have to back up their predictions with money; buy the right presidential contract and you win, buy the wrong one and you lose. Third, the profit motive encourages people to look for better information.

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