Prediction Markets: Distilling Collective Wisdom

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Case Details:

Case Code : BSTR268
Case Length : 14 Pages
Period : 1988-2007
Pub Date : 2007
Teaching Note :Not Available
Organization : --
Industry : Miscellaneous
Countries : Worldwide

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"We believe prediction markets can significantly improve decision making in the private and public sectors."¹

- Open letter from a group of economists sent to Congress and federal regulators, in May 2007

"Prediction market technology hadn't been applied to video games. For the consumer side, there's just so many games out there, and so many reviews to read, and what I believed was that not only could a prediction market help consumers identify what games and accessories would sell the best, (it could) also help professionals." ²

- Brian Shiau, Founder of SimExchange³, in 2007

Introduction

In May 2007, a group of more than 20 economists, including Kenneth J. Arrow of Stanford University, Daniel Kahneman of Princeton University, and Robert J. Shiller of Yale University, on behalf of the AEI-Brookings Joint Center for Regulatory Studies⁴, sent an open letter titled "Statement on Prediction Markets "to the US Congress. The letter suggested that prediction markets were effective forecasting tools and urged the government to "lower barriers to the creation and design of prediction markets by creating a safe harbor for certain types of small stakes markets."⁵ A prediction market may be defined as a speculative market created for the specific purpose of making predictions.

It is based on the premise that the aggregate of the predictions made by a large number of people would be more accurate than predictions made by a small group of experts.

Prediction markets are operated just like stock markets. If, for example, a prediction market was set up to predict an event (say, that the sales of a particular product manufactured by Company A would double in the next quarter), the price of the event in the market would typically indicate the probability of the occurrence of the event.

Prediction markets, as we know them⁶, have been around since the late 1980s, when the University of Iowa requested permission⁷ from the US Commodity Futures Trading Commission⁸ to start a prediction market which it later named Iowa Electronic Markets. This market became famous for accurately predicting the outcome of all the US presidential elections since 1988.

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1] Kenneth J. Arrow, et. al, "Statement on Prediction Markets," http://bpp.wharton.upenn.edu, May 2007.

2] Daniel Terdiman, "SimExchange Aims to Predict Video Game Market," www.cnetnews.com, May 18, 2007.

3] The SimExchange, developed in November 2006, is a virtual stock market game, with members predicting the sales of game hardware and software.

4] The American Enterprise Institute and the Brooking Institution established AEI-Brookings Joint Center for Regulatory Studies in 1998. The main objective of the center is to hold lawmakers and regulators accountable for their decisions by providing objective analyses of existing regulatory programs and new regulatory proposals.

5] Kenneth J. Arrow, et. al, "Statement on Prediction Markets," http://bpp.wharton.upenn.edu, May 2007.

6] Some analysts consider prediction markets as any other futures market; even calling them event futures. In that sense, these markets have been around since the mid-1800s. However, if we consider prediction markets as those specifically designed to predict outcomes/events, then the IEM set up in 1988 is the first such market.

7] Though all forms of gambling are legal under US federal law, most states have either banned all forms of gambling or allowed permission only to some forms. Operators, to be safe, take permission from the Commodity Futures Trading Commission to set up small stake (real money) prediction markets, as a CFTC license overrides the anti-gambling laws of the states.

8] The US Commodity Futures Trading Commission was set up by the US Congress in 1974 as an independent agency with the mandate to regulate commodity futures and options market in the USA.