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The prices in these markets predict expectations as
varied as terrorist threats, the extent of a flu epidemic, the
success of a new drug, the revenues from a new product, the timing
of a product launch, and the quality of a new software program
Prediction markets KENNETH J.
ARROW and 21 other economists are calling for the revision of state
and federal anti-gambling laws in order to allow prediction markets
to develop to their full potential. (Science, May 16, 2008)
“Prediction markets,” quoting
from their paper, “are forums for trading contracts that yield
payments based on the outcome of uncertain events.”
Such markets, they continue,
“produce forecasts of event outcomes with a lower prediction error
than conventional forecasting methods.”
The example that was used was the
Iowa Electronic Markets (IEM). The IEM is run by professors at the
University of Iowa. It was set up, initially, to predict two-party
presidential elections in the US. Today, it makes forecasts of other
social and economic events.
In the 1988, 1992, 1996 and 2000
presidential elections, the IEM’s error between its forecast of
share of votes and the actual votes received by either party was 1.5
percentage points. By contrast, the error of the final Gallup poll
was 2.1 percentage points. The IEM’s longer-run forecasts were
“impressive.” Its average error was only 5 percentage points 150
days before the elections. Other polls like Gallup had much larger
errors in their predictions.
Thus, prediction markets can aid
in decision-making. They are now used by the US Department of
Defense and by corporations like Eli Lilly, General Electric, Google,
France Telecom, Hewlett-Packard, IBM, Intel, Microsoft, Siemens, and
Yahoo.
The prices in these markets
predict expectations as varied as terrorist threats, the extent of a
flu epidemic, the success of a new drug, the revenues from a new
product, the timing of a product launch, and the quality of a new
software program.
The range of its applications is
constrained, however, by laws limiting Internet gambling. Unless
prediction markets are made “unambiguously legal” they cannot
develop into “vibrant and liquid markets,” Arrow et al said.
Prediction markets work because
they are a mechanism for aggregating information that in a free
market is widely dispersed among many actors. Given an incentive for
profit, there will be a stronger motive to search for better
information.
Since it’s not realistic to
repeal anti-gambling laws, Arrow et al suggest that only “three
types of entities” be made eligible for legal, regulatory
treatment.
The first type would be
not-for-profit research institutions that include universities,
colleges, and think tanks that want to operate exchanges like the
IEM.
The second would be government
agencies that want to undertake research similar to those done by
entities of the first type.
And the third are private
businesses that are primarily engaged in research but would be
allowed to operate internal prediction markets with their employees
or contractors.
Markets in all three cases should
be limited to small-stakes contracts. The definition of small stakes
should be formulated by the appropriate government regulator.
Although all three types are not
for profit, they should be allowed to recoup administrative and
regulatory costs by charging fees that, again, should be determined
by a regulatory body. Furthermore, brokers, paid consultants and
advisers should be barred in order to reduce the risks of
inappropriate use. The exchanges should be self-policing and should
make every effort to prevent their outputs to be manipulated or used
fraudulently.
The regulator should “allow
contracts that price any economically meaningful event.” This
would allow, as in the case of the IEM, contracts on political
events, environmental or health risks, or economic indicators but
not on the outcomes of sports events. This will contribute to more
efficient allocation of risks.
Prediction markets are still in
an early stage of development. Hence, those who are given permission
to operate exchanges should take it upon themselves to experiment
with all the aspects of prediction markets such as fee structures,
incentives against manipulation, capitalization and so on.
Finally, the exchanges should
inform their users of both the risks and benefits of participation.
Our political, social and
economic institutions would be strengthened immeasurably by the
creation of prediction markets—by law.
For more information about
prediction markets the following might be useful: K. Arrow et al
“Statement on prediction markets,” AEI-Brookings Joint Center
Related Publication No. 07-11 (May 2007) available at Social Science
Research Network (SSRN) http://ssrn.com/abstract=984584; No-action
letter from Andrea M. Corcoran, Director, Commodity Futures Trading
Commission (CFTC) Division of Trading and Markets, to George R. Neumann,
Professor of Economics University of Iowa (5 Feb 1992) www.cftc.gov/files/foia/repfoia/foirto5036003.pdf.;
J. Wolfers, E. Zitzewitz, “Interpreting prediction market prices
as probabilities,” Stanford Graduate School of Business, (2005).
opinion@manilatimes.net
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