The Probability Estimate Prediction Market
Prediction markets may take many forms, and some of the designs for prediction markets that this book considers might not merit being described as markets at all. The term prediction market, however, is descriptively accurate at least as applied to the design most prevalent today, which I call the “probability estimate prediction market.” As the name suggests, its purpose is to produce a certain type of information, in particular, an estimate of the probability of a designated event. In most markets goods or services are exchanged for money, and the price provides a kind of information, specifically about the value of the good being exchanged relative to the value of other goods. The real purpose of the market, however, is to facilitate the exchange, with the price simply a by-product of the actions of market participants. In a prediction market, by contrast, the exchanges themselves will generally have no economic function (except in some cases for hedging purposes; see Chapter 3). A prediction market’s purpose is to produce a price that the creator of the prediction market finds useful. Consider, for example, a subject that recently was of great import: whether the actress Angelina Jolie and the actor Brad Pitt will marry. Suppose that Us Weekly wished to provide its readers with the most accurate information possible about the probability that a marriage would result by January 1, 2010. Of course, Us Weekly presumably wants to present its readers with a range of relevant information, such as reports of supposed friends and analyses by body language experts who scrutinize photographs of celebrities as they seek to escape from the paparazzi. But it might also want to provide a concrete number, an estimate of those in the know of the chance that the marriage really will happen. This would be useful both for readers in a hurry and for readers who are unsure of their own ability to weigh the different pieces of evidence. Of course, Us Weekly might simply make up a number, but such numbers might seem arbitrary or sensationalistic. If it wanted to produce a more credible estimate, it might launch a probability estimate prediction market. Here is how such a prediction market might work, placing aside for now concerns about whether creation of such a market in the United States would be legal (see Chapter 2): Us Weekly would sell two different kinds of tradable contract to the public, a marriage tradable contract and a no-marriage tradable contract. For example, it might hold an on-line auction for one hundred of each type of share. It would promise to issue a fixed payoff, say, one dollar, on January 1, 2010, depending on whether Jolie and Pitt in fact become married by that date. So, should they become the Jolie-Pitts by that date, each marriage tradable contract would be redeemable for one dollar on that date, but the no-marriage tradable contract would be worthless. On the other hand, should Jolie and Pitt not be married to each other by that date, then the no-marriage tradable contract would be redeemable for one dollar on that date, but the marriage tradable contract would be worthless. In announcing the prediction market, Us Weekly presumably would seek to limit the possibility of ambiguities, such as whether a marriage followed by a divorce would count. But if there were ambiguities, then Us Weekly would resolve them either after or before the payoff date. The initial auction of such tradable contracts itself would produce some information that could help assess the tradable contracts. For example, suppose that the marriage tradable contracts sold for an average of about sixty cents, and the no-marriage tradable contracts sold for an average of about thirty cents. That would seem to indicate that the marriage share is considerably more likely than the no-marriage share to be redeemed for one dollar. Hazarding a specific probability from such information would be difficult, however. Perhaps the purchasers of the marriage tradable contracts are sentimentalists, willing to indulge their romantic notions for a collective total of sixty dollars. This is not a fully satisfactory answer, for it does not explain why the no-marriage tradable contracts did not sell for more. After all, if marriage seemed unlikely, at thirty cents each, the no-marriage shares would have been a bargain, and someone should have had an incentive to bid more for them. But given the inherent uncertainty of celebrity love lives, playing in the market carries some risk and demands some transactions costs, which include at least the time it takes to purchase and redeem shares. These factors can explain why the combined auction prices might be less than one dollar. Meanwhile, the possibility that individuals might obtain pleasure from holding tradable contracts independent of their financial value will tend to push prices up. Whether the initial tradable contracts are distributed by auction or by some other means, the key to the prediction market is that holders of tradable contracts can sell them. Typically, an on-line exchange serves to facilitate such transactions. Someone interested in purchasing the marriage tradable contract could submit a “bid price,” the price the potential purchaser would be willing to pay for that tradable contract. Someone interested in selling it could submit an “ask price,” the price at which an owner of the tradable contract would be willing to sell it. Whenever a bid or an ask is submitted, the exchange would seek to pair the offer with another. For example, if I offer to sell a marriage share for sixty cents, and then you offer to buy a marriage share for up to sixty-five cents, the on-line exchange could then complete a transaction, presumably at sixty cents, since the offer to sell came first. When an offer does not immediately find a match, it is placed in a queue, with the best offers placed at the front of the queue. At any given time, the on-line exchange maintains a “bid queue” and an “ask queue.” At the front of the bid queue is the most generous offer to buy, and at the front of the ask queue is the most generous offer to sell. The ask price will always be greater than the bid price, because when a new offer matches an existing one, a transaction is immediately completed. In economics, this arrangement is known as a continuous double auction.10 Just as the auction prices provide some indication of the probability of the Jolie-Pitt union, so, too, can the bid and ask prices provide some hint. For example, suppose that the bid price is fifty-five cents and the ask price is sixty cents. That would indicate that no one is willing to sell the tradable contract for less than sixty cents but that there are people willing to buy the tradable contract for fifty-five cents. If the event were viewed as having a significantly more than 60 percent chance of occurring, then one would think that someone would be eager to purchase the tradable contract for more than sixty cents. If the event were viewed as having a significantly less than 55 percent chance of occurring, then one would think that someone would be willing to sell for less than fifty-five cents. The midpoint of the bid and ask prices might thus provide at least a rough probability estimate, and this estimate may be averaged with the corresponding estimate from the no-marriage tradable contract. An alternative approach to deriving a probability estimate would be to base it on the most recent transaction or possibly on an average of several recent transactions. Either way, a significant advantage of a prediction market is that it will produce data that change over time as new information becomes available.
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