Prediction Markets

Instructor: Alex Tabarrok, George Mason University

Prediction Markets : Speculative markets for trading on the outcomes of events. This allows prices to be interpreted as probabilities and used to make predictions.

Prediction Markets: Speculative markets for trading on the outcomes of events. This allows prices to be interpreted as probabilities and used to make predictions. This is from the video “Prediction Markets” in the Principles of Microeconomics course.



Prediction markets are speculative markets, which have been designed so that the prices can be interpreted as probabilities and use to make predictions. One of the most famous of these is the Iowa Electronic Markets. I encourage you to go to the web and check them out. Traders on the Iowa Electronic Markets buy and sell shares of political candidates, and the prices of the shares can be used to predict the outcomes of elections.

Let me give you an example. Here's the case of the Iowa Electronic Markets from the 2008 election between Barack Obama and John McCain. In these markets, one Obama share pays you a dollar if Obama wins and pays you nothing, otherwise. One McCain share pays you a dollar if you hold the share and McCain wins, and pays zero if he loses.

Now, suppose you think Obama has an 80% chance of winning that election, how much would you be willing to pay for an Obama share? Well, if an Obama share pays a dollar if Obama wins and he has an 80% chance of winning, then that share is worth 80 cents. You would be willing to pay up to 80 cents for such an Obama share. Suppose you enter this market and you find that these Obama shares are selling for 65 cents, well, that's a buying opportunity. Something, which you think is worth 80 cents is selling for 65, so then, you should buy Obama shares.

In buying the shares, you would be pushing up their price. In this way, your predictions, your information, your opinions about which candidate is likely to win become incorporated into the price of an Obama share. By the way, suppose you thought Obama had an 80% chance of winning, but his shares were selling for 90 cents, well then, you would want to share Obama shares. Even if you're an Obama supporter, to make more money you would sell the Obama shares and buy the McCain shares. Again, in this way, prices come to reflect the information.

There are lots of traders in these markets. People who are very politically astute, who understand the electoral college, and who understand how elections work, and how well, or how badly a campaign is going. When these individuals buy and sell shares, their information comes to be reflected in the market prices.

Here are the actual prices on August 8th, 2008. Obama shares were selling for 63 cents per share and McCain shares were selling for 37 cents. The market was predicting a high likelihood of an Obama win and in fact, that did, of course, turn out to be the case. In over 20 years of testing these markets, in presidential elections, congressional elections, and state elections, these market prices from the Iowa Electronic Markets have turned out to be better predictors of the outcomes than half political polls. That makes a lot of sense. Think about it.

With real money on the line, people have an incentive to think carefully when they're investing and they have an incentive to collect and process and interpret all of the information from available all over the world. The resulting market prices reflect a lot of deep-seated information and indeed interpretation in a way, which political polls simply, cannot.

Ask a Question

Please register or login to ask a question