Aha!#1 — Prediction Markets

Crowd’s wisdom for predicting outcomes with a skin in the game approach.

Welcome to the”Aha!” post series. This is the spot where we get excited about discovering new things. Learning isn’t just a hobby — it’s an addiction, and I’m hooked. Every week, I’m going to share a cool topic that’s caught my eye while I’m out there exploring.

We all know that it’s impossible to know everything, but why settle for less? Stick around if that sounds like your thing.

Imagine a market where you can “bet” on the outcome of future events, from who will win the next election to whether we’ll discover life on Mars. Sounds crazy, right? Well, it’s not. These are prediction markets, and they’re quietly gaining traction as a powerful tool for forecasting the future.

A prediction market is a marketplace where people trade on the outcomes of uncertain future events. Instead of just expressing opinions, participants buy and sell contracts representing different possible outcomes, using real or virtual currency. The prices of these contracts fluctuate based on supply and demand, reflecting the collective wisdom of the market participants about the likelihood of each outcome.

But how do these markets work, and more importantly, where does their predictive power come from? We’re diving into prediction markets with some real-life examples!

How it works:

Let’s say there’s an upcoming election. In a prediction market, you might be able to buy shares predicting which candidate will win. If you believe Candidate A will win, you’d buy shares in that outcome. If Candidate A does win, the value of those shares goes up, and you can sell them for a profit. If Candidate B wins, the value of your shares goes down.

Wisdom of the Crowd, Money on the Line:

Unlike traditional polls, prediction markets offer more than just opinions. Take PredictIt, a popular platform. Here, you can buy virtual shares representing different outcomes of an event, like the winner of the US presidential election. Each share’s price reflects the collective prediction of the market participants. This diverse mix of individuals brings a broader understanding than polls or expert opinions, often uncovering hidden signals.

But here’s the thing:

you’re using real money, albeit virtual on platforms like PredictIt. This “skin in the game” approach incentivizes research and informed bets. Imagine two friends discussing the election: one casually guessing, the other researching candidates and policies before buying PredictIt shares. Who do you think has a more accurate prediction?

Robin Hanson, a professor at George Mason University, is a strong supporter of prediction markets says “Let us create betting markets on most controversial questions, and treat the current market odds as our best expert consensus. The real experts (maybe you), would then be rewarded for their contributions, while clueless pundits would learn to stay away,”.

Markets Reflect Information, Like Magic (Almost):

Now, picture a constant flow of news and updates impacting the event. In prediction markets, like the Iowa Electronic Markets (IEM) focusing on US politics, participants react by buying or selling shares based on this new information — Launched in 1988, it has been proven to be more precise than standard public surveys in accurately anticipating the outcomes of presidential elections — This dynamic process adjusts the share prices, ultimately reflecting the collective assessment of the news’ impact. It’s like a filter, revealing the clearer picture amidst the noise and misinformation.

Beyond Experts, a Symphony of Knowledge:

Prediction markets aren’t just for political pundits. Imagine a scientist on Augur, a decentralized prediction market platform, buying shares on the likelihood of a specific medical breakthrough. They might have unique insights valuable to the prediction, even if they’re not a household name in the field. This diverse pool of knowledge surpasses the expertise of any single individual or traditional forecasting method.

Prediction markets stand strong against meddling, with two key presumptions in place. Firstly, individuals make decisions based on information with the strong incentive of profit, not market volatility. Secondly, those attempting to control the market don’t have access to the information flow. When these assumptions hold, the crowd plays a crucial role in determining proper values based on their best read of the available information in the search for profit.

Constant Learning, Real-Time Adjustments:

Prediction markets are living organisms, constantly adapting. As new information emerges, like a surprise political gaffe, participants adjust their positions, influencing the share prices. This real-time feedback loop allows the market to adapt quickly, potentially leading to more accurate predictions as the event unfolds.

But Hold On:

Despite their power, prediction markets aren’t perfect. Not all events, like the discovery of a specific archaeological treasure, might have established markets. Additionally, some individuals with privileged information might have an unfair advantage, highlighting the importance of market transparency.

The Future is Uncertain, But We Can Peek:

While prediction markets aren’t fortune tellers, they offer a unique and powerful tool for forecasting the future. By harnessing the wisdom of crowds, incentivizing research, and adapting to change, they can unlock valuable insights into the uncertainties that lie ahead.

Potential of Prediction Markets:

These markets hold potential in aiding private companies and public entities to efficiently manage economic risks like dips in consumer demand, and social risks such as flu epidemics and environmental catastrophes. However, in most countries, laws that impose restrictions on gambling pose notable obstacles to the formation of liquid prediction markets. Supporters propose that regulators ease these obstacles by establishing a legal safety zone for specified kinds of small-stakes markets, fostering innovation in their structure and application. Blockchain and token economy are also to be applied for creating prediction markets to soften the regulatory capture.

I’ve heard about the prediction markets while listening to this podcast with Vitalik. You might also like to give it a listen to see its relation with blockchains and decentralization.

Resources

Affecting Policy by Manipulating Prediction Markets: Experimental Evidence1

Prediction markets can tell the future. Why is the US so afraid of them?

The Wager That Betting Can Change the World

Corporate Prediction Markets: Evidence from Google, Ford, and Firm X1