What is a Prediction Market?

The prediction market is a collection of people speculating on a variety of events—exchange averages, election results, commodity prices, quarterly sales results or even such things as gross movie receipts. The Iowa Electronic Markets, operated by faculty at the University of Iowa Henry B. Tippie College of Business are among the better-known prediction markets in operation.

Key Takeaways

  • Prediction markets are markets that bet on the occurrence of events in the future.
  • They are used to bet on a variety of instances and circumstances, from the outcome of presidential elections to the results of a sporting event to the possibility of a policy proposal being passed by legislature.
  • Prediction markets depend on scale; the more individuals participate in the market, the more data there is, and the more effective they become.

Understanding Prediction Market

Robin Hanson, a professor at George Mason University, is considered among the tireless advocates of prediction markets. He makes the case for prediction markets by emphasizing the removal of reliance on self-interested punditry by so-called experts. "Instead, 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," he writes on his web page and even goes to the extent of proposing a new form of government based on idea futures.

The prices in a prediction market is a bet that a particular event will occur. It also represents an estimated value that the person placing the bet assigns to the parameters being considered in the bet. Unlike public markets, where bets are placed indirectly on intangibles such as government policy or the possible outcomes of an election, prediction markets enable users to bet directly on a piece of information that they believe is valuable.

For example, it is impossible for a speculator to bet directly on an election in the U.S. Instead, the trader will have to find stocks that might increase in value if a certain candidate is elected. But prediction markets allow traders to bet directly on the possibility of actual candidates being elected to office.

The Future of Prediction Markets

Because they represent a wide variety of thoughts and opinions—much like the markets as a whole—prediction markets have proven to be quite effective as a prognostic tool. As a result of their visionary value, prediction markets (sometimes referred to as virtual markets) have been utilized by a number of large companies—like Google, for example.

The blending of economics, politics, and more recently, cultural factors, has only made the demand for prediction even greater. Add the benefits of data analytics and artificial intelligence; we're living in the golden age of data and statistical utility.

Over the past 50 years, prediction markets have moved from the private domain to the public. Prediction markets can be thought of as belonging to the more general concept of crowdsourcing which is specially designed to aggregate information on particular topics of interest. The main purposes of prediction markets are eliciting aggregating beliefs over an unknown future outcome. Traders with different beliefs trade on contracts whose payoffs are related to the unknown future outcome and the market prices of the contracts are considered as the aggregated belief.

In theory, by pulling information from every available source, estimation methods should improve and become more accurate and consistent. In reality, as we're currently learning, data manipulation brings a host of new ethical and human biases which must be adjusted for. As leaders of all varieties help everyday individuals trust and appreciate prediction markets, their use and effectiveness will only improve further.

Examples of Prediction Market

The Iowa Electronic Market (IEM) is among the pioneers of prediction markets on the Internet. The University of Iowa's Tippie School of Business established it in 1988 and used it to predict the winners of the presidential election that year. Another example of a prediction market is Augur, a decentralized prediction market based on the Ethereum blockchain.