Prediction markets

Last week I wrote about how voters’ poor incentives to gain information lead to their ignorance of political issues. The implication was that better incentives would lead to better information. The question is how do we improve incentives? Secondarily, is there any evidence to show people with an incentive to collect information actually do it?

A number of opinion surveys have shown that the general public has great difficulty answering questions correctly about the federal government’s budget. I suggested that this is because each individual voter has very little say about what government does – especially the federal government – owing to the small probability of affecting an election. In short, voters don’t know what’s happening on Capitol Hill because there is little incentive to research it. If they had more of a stake in the outcome of the election, I think they would try harder to obtain information about government.

How do we give people a stake in the outcome of some event, such as an election? One way of doing that is to give the person a pecuniary award for possessing correct information. If people know that they can benefit financially from being smart, that is a good incentive to become smart. Luckily for us, there is already an institution that rewards people for correct beliefs, and it is known as a prediction market.

A prediction market is a speculative market in which the participants bet on whether or not a specific event in the future will occur. The most famous example of a prediction market is the market run by a company known as Intrade. Intrade allows its customers to bet on the outcome of political races and other events from the world of entertainment. For instance, Intrade allowed users to bet on who was going to win American Idol, whose season concluded earlier this week. Customers take bets on a contract that pays the buyer $10 if the event comes true, or more specifically here, if the candidate wins the competition. When there are many contestants early in the season, the odds of any one candidate winning are slim, which is why the bets for each contestant are typically low. Exactly how high or how low the bets are is a function of what the bettors believe is the probability of the contestant winning.

The contestant Crystal Bowersox was considered a favorite to win the competition a month ago, both by the show’s judges and by customers of Intrade. When there were six contestants remaining in late April, Bowersox was a 7-3 favorite to win the competition, according to the bets Intrade customers were making. By mid-May, Bowersox was an even-money bet. After Bowersox and fellow contestant Lee DeWyze faced off in the final performance Tuesday night, Intrade users had shifted their allegiances and were giving 4-1 odds that DeWyze would win. The results of the fan voting were announced Wednesday and DeWyze was declared the winner.

How could Intrade customers know with such certainty that DeWyze was going to win? How could they know how millions of people would vote on the final day? The answer is none of them knew. In fact, each bettor only had access to a tiny sliver of information. Through the use of prediction markets, a person can use that sliver of information to aid him in making a bet.

Suppose that the American Idol judges panned a contestant’s performance, but all the people you talked to at the local gym said they liked it. That is useful information. If everyone else at Intrade is putting very low odds on that contestant winning, the piece of information you have suggests the other bettors are underestimating the contestant’s chances. That means there is an opportunity for you to put your knowledge to work and make a buck by placing a bet on that contestant. When thousands of people do the same thing – making bets on the theory that they possess information other people don’t – the resulting odds reflect the collective knowledge of the betting pool’s members. By rewarding accurate bets and punishing inaccurate ones, the system provides an incentive to bet only when you have good information. Because prediction markets contain (mostly) good information, the betting odds you see in such markets closely reflect an event’s true probability, as evidenced by the markets’ proven track record.

For more information, watch this report the ABC series 20/20 did on prediction markets.

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