What Is a Prediction Market?

The prediction market is a market where people can trade contracts that pay based on the outcomes of unknown future events. The market prices generated from these contracts can be understood as a kind of collective prediction among market participants. These prices are based on the individual expectations and willingness of investors to put their money on the line for those expectations.

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 where contracts that are contingent on the occurrence of events in the future can be traded.
  • These contracts are similar to bets on uncertain events, and prediction markets are also known as betting markets
  • 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.
  • 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

Prediction markets are similar to futures markets for commodities or other financial asset prices. In futures markets, traders bid up or down the price of a future contract based on their expectation of what the future price of the underlying asset will be. Prediction markets are just futures markets where the future event being traded upon is something other than the price of an asset at some point in the future. Prediction markets involve a collection of people speculating on a variety of events—exchange averages, election results, quarterly sales results, or even gross movie receipts.

Robin Hanson, a professor at George Mason University, is an advocate 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," Hanson says on his web page.

The price 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 (via the effects these things are expected to have on asset prices), 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. However, 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.

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. Crowdsourcing is specifically designed to aggregate information on particular topics of interest. The main purpose of prediction markets is eliciting aggregating beliefs over an unknown future outcome. Traders with different beliefs trade on contracts whose payoffs are related to the unknown future outcome; 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. 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.