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Prediction Markets for Business and Public Policy the melbourne review Vol 3the Number melbourne 1 May 2007 review Prediction markets for business and public policy Andrew Leigh and Justin Wolfers Recent successes in prediction markets, n 2006, Google decided that it wanted to obtain better forecasts predicting both public events and corporate Iof what the company and its outcomes, have generated substantial interest competitors were planning to do. among social scientists, policy makers and the As with most firms, better predictions of product launch dates, office business community. While these markets have openings and so on are of significant their limitations, they may be useful strategic importance to Google. But instead of using the standard as a supplement to more primitive mechanisms approach — forecasting the future for predicting the future. by asking designated experts — 7 the melbourne review Vol 3 Number 1 May 2007 Google opted to set up a market, market, the price of a financial Prediction markets — an overview in which any Google staff member security or prediction market contract Perhaps the best-known type could bet on the chances of an event reflects all available information. of prediction market is election- coming true. If a Google staffer had Thus efficient prediction market betting markets. The Iowa Electronic strong information that an event prices hold the promise of yielding Market, established by political would come true, then regardless of efficient and unbiased forecasts; scientists at the University of Iowa her rank in the company, she could indeed, the market price may be in 1988, is perhaps the world’s bet on that outcome. The results not only the single best predictor of best known election market. These — based on the aggregated bets of the event but also the most efficient academics operate an electronic thousands of Google staff members aggregator of available information, market in which traders can purchase — were strong predictors of the such that no combination of available ‘futures contracts’ that consist of a actual outcomes. Where the trading polls or other information can be promise to pay $1 if the candidate volume was high, the forecasts were used to improve on the market- wins the popular vote. Thus the even more precise. And, as closing generated forecast. This statement price of this contract reflects the time drew closer, the markets became does not require that all individuals probability of a candidate winning steadily more accurate.1 in a market be rational, as long as the election.3 Assuming market This example describes an the marginal trade in the market efficiency, these prices should yield increasingly important information- is motivated by rational traders. Of assessments that reflect all available aggregation tool, known as ‘prediction course, it is unlikely that prediction information — including polls, the markets’.2 Analytically, these are markets are literally efficient but state of the economy, and recent markets where participants trade a number of recent successes in policy pronouncements. in contracts whose payoff depends on unknown future events — just as in any financial or betting market. The defining feature of a prediction market is that the The defining feature of a prediction price of these contracts can be directly interpreted as a market is that the price of these market-generated forecast of some unknown quantity. contracts can be directly interpreted as a market-generated forecast of some unknown quantity. Much of the these markets, both with regard For US presidential elections, the enthusiasm for prediction markets to predicting public events and Iowa Electronic Market has tended to derives from the efficient markets corporate outcomes, have generated be more accurate than opinion polls. hypothesis: in a truly efficient substantial interest among social Research has suggested that this is scientists, policy makers and the because the betting market focuses business community. on the underlying dynamics of the We begin by outlining the types of race, and is therefore better able to prediction markets currently on offer parse out events that occur several and then discuss their accuracy. We months before the election, but will 4 review what is known about how not change the outcome. Conversely, to design an effective market and the betting market responds rapidly the constraints of the present legal to occurrences that affect the regime. Finally, we discuss the kinds underlying dynamics of the race of inferences that can be drawn from (such as the appointment of a new prediction markets and conclude with campaign manager), even if these our own prognostications on what the events elicit relatively little response future might hold. in the media or polls. 8 the melbourne review Vol 3the Number melbourne 1 May 2007 review In Australia, looser regulation of Table 1: Some Popular Prediction Markets sports betting in the Australian Capital Territory and the Northern Market Focus Typical turnover on an Territory has led several bookmakers event ($US) — including Betfair, Centrebet, Iowa Electronic Small-scale election Tens of thousands International All Sports, SportingBet Markets markets. Similar of dollars <www.biz.iowa.edu/iem> markets are run by: and SportsAcumen — to offer (Traders limited to Run by University of UBC (Canada) <www. punters the ability to bet on election $500 positions) outcomes. Australian gamblers Iowa esm.buc.ca> and TUW wagered over $1.5 million on the (Austria) <http://ebweb. 2001 federal election, and over tuwien.ac.at/apsm/> $2.6 million on the 2004 federal Centrebet Northern Territory Millions of dollars election. While betting markets do <www.centrebet.com> bookmaker, offering not ‘look’ like financial markets, the For profit company odds on election betting odds yield the same directly outcomes, current interpretable forecasts offered by the events, sports and Iowa Electronic Markets. entertainment. TradeSports Trades in a rich set Hundreds of thousands Outside the political sphere, there <www.tradesports.com> of political futures, of dollars, sometimes is a growing number of web-based For profit company financial contracts, millions prediction markets, often run by current events, sports companies that provide a range and entertainment. of trading and gambling services. Economic Large-scale financial Hundreds of millions Some prominent examples include Derivatives market trading in the Tradesports.com (also known as <www.economic likely outcome of future InTrade.com) and Betfair.com, derivatives.com> economic data releases. and pseudo-markets (in which Run by Goldman Sachs participants trade virtual currency) and Deutsche Bank such as Newsfutures.com and Ideosphere.com. These websites often Newsfutures Political, finance, Virtual currency take the lead on defining a contract <www.newsfutures.com> current events and redeemable for monthly (e.g. in 2002–03, Tradesports ran a For profit company sports markets. prizes (such as a TV) market on whether Saddam Hussein Also technology and would be deposed as Iraqi leader), pharmaceutical futures and then allow individuals to post for specific clients. their offers to buy and sell contracts. Foresight Exchange Political, finance, Virtual currency In this respect, the market structure <www.ideosphere.com> current events, science largely shadows that in standard Non-profit research and technology events financial markets. group suggested by clients. Hollywood Stock Success of movies, Virtual currency Some prediction markets focus on Exchange movie stars, awards, economic statistics. For instance, <www.hsx.com> including a related set Goldman Sachs, Deutsche Bank, and Owned by Cantor of complex derivatives the Chicago Mercantile Exchange Fitzgerald and futures. Data used have launched markets on the for market research. likely outcome of future readings 9 the melbourne review Vol 3 Number 1 May 2007 of economic statistics, including in 2001, and only two out of four In a corporate context, the Hollywood employment, retail sales, industrial major pollsters in 2004.6 Stock Exchange predicts opening production, and business confidence. weekend box-office success and these Perhaps more interesting in terms Some markets also forecast private- predictions have been quite accurate. of how well prediction markets sector returns. The Hollywood Further, this market has been about can aggregate information is the as accurate at forecasting Oscar Stock Exchange allows people to performance of markets at the level 9 use virtual currency to speculate of the individual district. Typically, winners as an expert panel. Some on movie-related questions like districts are sufficiently small that firms have also begun to experiment opening-weekend performance, total there is little interest (or funding) for with internal prediction markets. An box office returns, and likely Oscar local polling. Yet when Australian internal market at Hewlett-Packard winners. In several cases (such as bookmakers started betting on produced more accurate forecasts the Google example above), private district-level races, we found that of printer sales than the firm’s own firms have found innovative ways to they were extremely accurate. In processes.10 Gerhard Ortner described use prediction markets as a business 2001, the Centrebet favourite won an experiment at Siemens in which forecasting tool. in 43 out of 47 marginal seats.7 an internal market predicted that the firm would definitely fail to deliver on a software project on time, even when Arguably, the most important
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