Prediction Markets
POLS 3220: How to Predict the Future
Hedgehog Professor vs. The Market
. . .
. . .
Today’s Agenda
What are prediction markets?
How do they work?
When should you trust them?
When should you be skeptical?
Probability As A Bet
Suppose I offered you a contract that pays $1 if it rains tomorrow.
Ponder: How much would you be willing to pay for this contract?
It depends on the probability of rain!
If \(P(\text{rain}) = 0.2\), then buying the contract for any price less than 20¢, will, on average, earn you a profit.
Prediction Markets
A prediction market is an exchange where people buy and sell these types of contracts.
The potential for profit creates strong incentives for participants to seek out good information and make good predictions (Arrow et al. 2008).
The “market price” for each contract reflects participants’ beliefs about the probability of that event.
Class Activity
To demonstrate how prediction markets work, we’re going to create our own.
Everyone starts the game with a sheet of 300 foxcoin and a stack of contracts.
- Your goal is to have the most foxcoin by November 19.
We’ll record the order book for each contract on the board.
If you want to buy a contract, put your name and the price you’re wiling to pay in the “Bid” column.
If you want to sell a contract, put your name and the price you’re willing to pay in the “Ask” column.
When do markets work best?
Trading volume is high.
- Just like we saw with the Condorcet Jury Theorem, the “wisdom of crowds” works best when the crowd is large.
Time horizons are short.
Market participants tend to have more accurate information the closer you get to an event.
Profit motive is much weaker for long-term contracts.
- There’s no incentive to accurately price a 10-year prediction contract when you could just put your money in US Treasury Bonds and earn 50% compound interest.
When should you be skeptical?
. . .
- Anyone who thinks the answer is less than 20% has no incentive to participate in this market!