The forthcoming presidential election has drawn attention to online predictions markets. The first, and one of the best known, is the Iowa Electronic Market (IEM), started in 1988 to bet on presidential elections. Participants can bet up to $500. The odds and hence the price of a contract are set by the bidders themselves, as in a stock market, rather than by the "house," as in casino gambling. A number of other prediction markets, some using virtual (i.e., play) rather than real money, have emerged, includingTradeSports.com, the Foresight Exchange Market, Newsfutures, Intrade, and the Hollywood Stock Exchange.
IEM, on which I'll focus, has correctly predicted the outcome of every presidential election since 1988, and its predictions have been consistently more accurate than the polls. An interesting comparison between the Gallup Poll and the Iowa market in the 1996 presidential campaign (www.biz.uiowa.edu/iem/media/96Pres_VS.html) reveals that throughout the entire campaign the Iowa market‚Äôs predicted outcome was much closer (in margin of victory) to the actual outcome than the Gallup Poll was. Studies have found that prediction markets beat polls and other prediction tools even when a prediction market uses play rather than real money.
The Pentagon planned to create a prediction market in which participants could bet on the likelihood of terrorist attacks, assassinations, and coups. The plan caused outrage and was abandoned. There was a serious objection to the plan: people planning terrorist attacks, assassinations, and coups have inside information which they could use to make a killing (pun intended) in the prediction market.
The success of prediction markets is related to though distinct from the success of the "blogosphere" in ferreting out information that eludes the mass media. Both the blogosphere and prediction markets aggregate greater amounts of information than any centralized information gatherer can obtain. In the case of the blogosphere, it is easy to see why this is so. It is virtually costless (except in time) to become a blogger, and among the millions of people drawn to blogging are people with all sorts of pockets of specialized information, which the internet enables to be pooled rapidly. This pooling resembles the economic market, in which vast amounts of information, encapsulated in prices, are pooled (the basic insight of Friedrich Hayek, and the secret of capitalism‚Äôs superiority to socialism as a means of optimizing economic activity).
Prediction markets provide an even closer analogy to the market, since they (or rather some of them, for others permit betting only with play money) provide financial rewards for correct information (as blogging rarely does), in this resembling ordinary commercial speculation. Someone who thinks he has superior insight into political processes will have an incentive to place a bet in IEM or some other political prediction market. This method of aggregating information--call it expert aggregation--is different from public opinion polling, which is based on randomness. The political pollsters quiz a random sample of likely voters for their likely vote; they do not ask them for an opinion of how other people will vote, a matter on which randomly selected respondents cannot be expected to have an expert opinion. The idea behind the prediction market is that the opportunity to make money or just the fun of betting on one's insights or hunches (the only reward that the virtual prediction markets offer participants) will elicit expert opinions--more so, certainly, than random polling, which anyway, as I have said, does not ask respondents for an opinion about anyone's voting except their own..
I don't think the success of prediction markets is due to a "wisdom of crowds" phenomenon--the idea that somehow large groups of seemingly nonexpert people are bound to "get it right." The "wisdom of crowds" is really just a matter of reducing sampling error. Suppose 100 people guess the weight of a person. Some will guess too low, some too high, but the average guess will be close to the true weight. If, however, just one person is asked to guess, the chances are great that his guess will be either too high or too low.
One problem with prediction markets, a problem that occurred on the day of the 2004 presidential election, is that a market can swing on the basis of unreliable information until the information is corrected. (That happened last week when the price of stock in United Airlines plummeted on a mistaken report that the airline was about to declare bankruptcy.) Exit polls showed Kerry winning a disproportionate number of the votes cast early in the morning, and immediately the prediction markets predicted that he would win the election; and of course he lost.
Another potential problem with the prediction-market model is that the limits of the bets that can be placed, illustrated by the Iowa market‚Äôs $500 limit, are so low. One understands why there are limits: otherwise there would be a danger of market manipulation. Expenditures on the current presidential election campaign will exceed a billion dollars. It must be that the prediction markets attract people who derive nonpecuniary satisfaction from successful bets and that among those people are likely to be a number who really do have insight into the issues bet on in the market, since their bets are more likely to be correct and therefore they are more likely to derive the satisfaction that comes from successful betting. Probably most people who bet on horse racing think they know something about horses, and probably most people who bet on the outcome of a political campaign know something about politics.
It may seem odd, though, that a stranger would have a better sense of how people will vote than a random sample of people would know, each of them, how he or she will vote. But only about half of all eligible voters actually vote in a presidential election, many people refuse to talk to pollsters, some people do not make up their mind until the last minute (but may be hesitant to reveal their indecision to a pollster), some respondents will tell the pollster what they think he wants to (or will be impressed to) hear, and the number of persons sampled is never large enough to avoid a confident prediction of a point outcome, as distinct from a range (say a 95 percent probability that one candidate's vote percentage will be between 47 and 50 percent and the other's between 49 and 52 percent).
There is an interesting question whether prediction markets should be thought of as "gambling‚Äù and perhaps prohibited. As a matter of policy, that would be a mistake, even if one thinks that gambling should be prohibited. The prediction markets are markets for speculation, rather than for game-playing or risk-taking. Slot machines, card-playing, roulette wheels, and other conventional forms of gambling do not generate socially valuable information. Speculation does. Commercial speculation serves to hedge commercial risks and bring prices into closer phase with value. Political, cultural, etc. prediction markets also yield socially valuable information. The outcome of elections is important to companies and even individuals for whom particular public policies are important; they may wish to make adjustments to avert or exploit looming political change. Politicians too need to have as sharp a sense as possible about the effects on the electorate of their and their opponents' strategies. Apparently they can get more accurate information from the prediction markets than from the public opinion pollsters.