POLS 3220: How to Predict the Future
What are prediction markets?
How do they work?
When should you trust them?
When should you be skeptical?
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.
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.
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.
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.
Trading volume is high.
Time horizons are short.
Markets tend to be more accurate the closer you get to an event.
Profit motive is much weaker for long-term contracts.