Prediction markets economists

FOR over a year, the prediction market site Intrade offered a contract on whether the Supreme Court would rule the Obamacare's individual mandate unconstitutional by the end of 2012. For most of its life, the contract traded below $5; the collective wisdom of the market suggested the mandate would stand. In late March, however, a surge of public scepticism about the Court's tolerance for the mandate led to an impressive jump in the price. By the eve of the Court's ruling, the market put the odds that it would be struck down at nearly 80%. Then the fateful day arrived—and on word that Chief Justice Roberts voted to uphold the mandate as a tax the contract instantly plummeted to near zero. So much for the wisdom of the markets, right?

Not quite, says a new NBER working paper by Erik Snowberg, Justin Wolfers, and Eric Zitzewitz. Their research sets out to show how prediction markets can provide the best available estimates of future events and figures. Yet while the paper argues strongly for the utility of markets, it also offers plenty of reason to treat their conclusions cautiously.

We all know the pitfalls of prognosis. I wrote yesterday about predictions of runaway inflation that stubbornly refused to materialise. The IMF revises its growth forecasts with striking regularity. My favourite false augury comes from snooty ex-Guardian man C.P. Scott: "Television? The word is half Latin and half Greek. No good can come of it." Comment is free, but not necessarily true, it turns out.

The question is, can markets do any better? There is good reason to believe so. Price signals shine a light on what hordes of individuals think: what they fear, want, value and are willing to bet on. What results is a truth greater than one man's opinion.

Prediction markets deal in bets. You pay $X to bet that, say, Vladimir Putin is hurled out of office. Or you pay $Y for a contract that rewards you $1 for every 1000 men unemployed. (Has Obama bought one?) Or you pay $Z, and you'll get double if unemployment is higher than x. From this you can calculate next month's expected job figures. On Intrade, you buy shares on a contract that pays $10 for one outcome (like, the mandate being struck down) and $0 for another. If you think a contract is trading at too high a price, you can sell it short.

There is no manipulation of data. The markets rapidly price in new information. And there is little arbitrage: you can bet for and against Mr Putin's exit; the probabilities add up to 100. For these reasons, the research paper found that prediction markets perform better than polls and forecasters. But they must nonetheless be handled cautiously; markets can be efficient and still be wrong. If markets are still mostly inaccurate, then their conclusions are of little use.

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