[Michael Abramowicz, guest-blogging, January 29, 2008 at 11:05am] Trackbacks
Prediction Markets vs. Conventional Wisdom:

I promised to start by addressing some common criticisms of prediction markets. What better way to start than by attacking my friend, GW colleague, and now co-conspirator Orin Kerr? Orin has at least twice (in 2005, and earlier this month) endorsed the criticism that the election markets don't seem to do much more than track the conventional wisdom. Orin is in good if unfamiliar company; Paul Krugman recently made a similar criticism.

Unfortunately for my attack, I don't entirely disagree. On issues for which there is likely to be lots of public information but little private information, prediction markets reflect what highly informed people believe. No better, but no worse. If you want to know what the probability is that X will be President, you probably won't be surprised by the prediction markets, but on average over many independent events the market's predictions will probably be at least slightly better than the ones you would make on your own.

A stronger version of this criticism insists that the markets are worse than the highly informed conventional wisdom. Critics will say that the markets put too much weight on the pro-Obama pre-New Hampshire polls or the pro-Kerry 2004 exit polls. I'm skeptical of this criticism. At any time, the markets may be slightly off, but if they have obvious, large imperfections, people will trade back to more sensible values.

Usually, such criticisms are made after the fact, and they often reflect hindsight bias. It seems obvious now that election observers put too much weight on the pro-Kerry and pro-Obama polls. But even the most sophisticated analysts may have trouble afterward figuring out why (see here on 2004 and here on 2008).

The real problem is that our models of voter behavior aren't as good as we'd like to think. No one cries foul because Tradesports.com gave the Giants a 1% chance in early October of winning the Super Bowl. Football is full of surprises. But whenever something unexpected happens in an election, we feel that we should have expected it all along.

Some might still object that if prediction markets do no more than reflect the fallible informed conventional wisdom, they aren't worth much. And indeed, election markets may do little but save some of us the time of reading the election news. But in a world of ideology, special interests, and agency costs, institutions could do a lot worse than rely on prediction markets in their decision making. The central argument for prediction markets for me is not that they are magically accurate, but that they are fairly objective.

But there is one other final point, hearkening back to yesterday's post: Many prediction markets that would be useful to institutions are on topics on which there may be little public or private information. It is especially important to constrain opportunistic decisionmakers when they are making claims that few if any people have the information to assess. With subsidies and automated market makers, these markets will not merely reflect existing conventional wisdom, but give incentives to a few individuals to do research and make disinterested forecasts.