A Speculative Inquest

-- By JuliaS - 09 Feb 2008

Introduction

Just as a provisional introduction before I get around to writing a real one: Last Friday I discovered these things called "Prediction Markets" while I was looking for new places to gamble online. (Check out intrade.com - it's pretty self-explanatory.) The ramifications of the prediction markets are pretty fascinating. That last sentence may end up being my thesis if I can't figure out anything more coherent to say.

What are prediction markets?

The most interesting thing ever.

How do they work?

What are they used for?

Forecasting, decision-making, risk management

What is information aggregation?

Prediction Markets and Judicial Decisions

Markets for Trials

Consider the markets for trials. There are thousands of people currently trading on InTrade in the market for the outcome of Tom Delay's criminal trail. Thousands of people with (presumably*) no actual knowledge of Tom Delay's activities are betting their money on whether or not he is guilty. But that doesn't make any sense - how can we form opinions about events we have no connection to? Why would rational, financially motivated investors insist on the truth of a proposition they have no real knowledge of? Simply put: they wouldn't. These people are not betting on the factual truth of the charges - they aren't asserting that Tom Delay is actually guilty of money laundering - rather, they are merely anticipating how the court will decide. In a way, the very existence of these markets admits Frank’s modern legal magic. We can make a game out of predicting the outcome of cases, even though we have no idea about the truth of the issue on trial, simply because we understand the mechanisms of our legal process. Assuming shareholders are astute, the market will fluctuate in predictable ways as new information relating to the trial surfaces. If these markets existed in the early nineties, the price of shares for an acquittal in the Rodney King case would have soared the moment the trail was moved to Simi Valley. The markets reflect an honest understanding of the nature of our legal system.

*This is an important presumption. See InsiderTrading? for more on this.

Speculating about Speculating

There is another possibility, however, regarding the nature of the predictions. Given that the market system allows people to buy and sell their shares at any time, it is possible that enterprising speculators are not actually making any judgment about outcome of the trial, but instead are merely speculating about how other people will predict the outcome. That is, a savvy investor might anticipate how others think Tom Delay’s trial will turn out, then buy low, and sell high, all without ever forming any judgment of his own. The prediction markets reward people who can successfully anticipate what other people will expect the Court will decide; it is the market version of the "reasonable man" standard that we see so often in the law.

Markets for Supreme Court Cases

"Matters of Law"

Law by Consensus

Markets as Judges/Juries

Imagine if, instead of juries, we create a prediction market for trial verdicts. We post a transcript of the trial online and allow people to buy shares of the outcome they think is correct. We announce the date that the market will expire, and on that date we enter whatever verdict has a higher value in the market. As an investor, you have a financial interest in accurately predicting what other people will think the verdict should be. The market mechanism here performs essentially the exact same function as the "reasonable man" standard we employ in much of our legal decision-making, by incentivizing investors to figure out how the average person will interpret the case. By extension, it creates an incentive for investors to advocate for their position - the more people who agree with you, the more your shares are worth. Imagine if the prediction market had a talk page associated with it, giving investors the opportunity to argue for their positions on the case. The market could potentially fulfill the role of attorneys as well as juries by providing financial incentive for effective advocacy.

Shantih, shantih, shantih.

In a certain sense, prediction markets for judicial decisions seem absurd. It almost seems to mock the legal system, robbing it of its pomp and solemnity. Imagine if we opened markets for sentencing in capital punishment cases - how morbid and perverse! The notion of betting on whether someone lives or dies is offensive to our moral sensibilities. How could we make a game out of such a grave matter? The idea of prediction markets as juries is even more ludicrous. We have modeled our system around the notion that the mob must be contained – certainly we cannot hand over our most sacred legal function to market speculators. It’s offensive to our notions of justice and demeaning to the value of our judicial verdicts.

But indeed, perhaps that's precisely the point. Maybe prediction markets have stumbled upon a way to reconcile the dilemma exposed in Frank's Modern Legal Magic. If the uncertainties of our legal system are, as Frank contends, both irreconcilable and unbearable - where does that leave us? What do we do about something we can neither fix nor endure? It might sound foolish, but maybe - just maybe - the answer is that we laugh at it. Rather than succumb to the crushing weight of responsibility for an uncertain legal system, we recognize it for what it is, admit that it cannot be solved, and then we don a cynical smile and do the only thing we can do: Try to profit from it.

Prediction Markets for World Events

Incentives for Sharing Information

Analysts have found that prediction markets tend to be rather accurate - markets for elections are more precise than Gallop polls, prediction markets for stock market behavior outperform experts economists. Admittedly, the markets have not been around long and ideas about their accuracy are largely unverified. But, in the abstract, it makes sense that they should be accurate. People with good information have an incentive to share it. People without expertise have incentive to stay out of the market, lest they eventually lose their money. Prediction markets are an extraordinarily efficient way to aggregate information.

The first prediction market was created by DARPA, a research group within the Department of Defense, as an experiment in predicting geopolitical risk, by creating markets for social and political events. The project was widely criticized as an endeavor in "betting on terrorism," and eventually shut down. And the critics had a point: by creating markets for the prediction of terrorist activity, DARPA could have unintentionally caused such activity. Prediction markets for any unwanted event are problematic; a sinister actor could invest all his money in the prediction that a terrorist attack will occur tomorrow, and then going out and commit one in order to collect on his bet. But ironically, this effect actually fulfills the original goal of the DARPA project - to aggregate information as a way of predicting events. When the would-be terrorist starts trading for shares of the market that predicts his attack, the market sees it. It's as though he is announcing his intentions, issuing a warning to the Department of Defense. Moreover, any person at all with any information - not only the would-be terrorist - has a strong incentive to share it. The more accurate and less known the information is, the more valuable it is to the speculator. It's arguably more likely that the market will simply act as a harbinger of impending events than it is likely that it will actually catalyze those events. That is to say, it seems unlikely that a man who is not already inclined to commit atrocities will be persuaded to do so simply because of opportunity to profit through the market. But if terrorist activity is already being planned, those who are aware of it have a clear incentive bet that information on the market.

Insider Trading

Time Magazine reports: On Dec. 11, 2003, InTrade? 's contract on Saddam Hussein's capture suddenly began to move. "We noticed that that contract started trading from 9 to 30 for no reason," says Mike Knesevitch, communications director. "Something was happening." In fact, someone may well have been trading on inside information. Two days later, Saddam was in custody.

Information as a Commodity

Prediction markets may have the potential to generate enormous wealth - it's a whole new economic frontier. But there is something conceptually curious about trading in predictions. Unlike traditional economic markets, the shares you are buying when you invest in a prediction do not represent any tangible, real world thing. When I buy stock in Pepsi Co., technically speaking, I own a percentage of the Pepsi Company and my stock entitles me to a share of its profits. But when I buy stock in the prediction that Antonin Scalia will be the next Supreme Court Justice to leave the bench, what have I bought? What creates the value in this market? It's similar, of course, to standard forms of betting, in that the value is the probability that an event will occur. But standard betting games are not conducted in market-form. The closest analogy I can come up with is the bond market - which trades in debt securities whose values are determined by their future performance. However, those securities are representative of real financial value-assets in a way that event predictions are not. Frankly, I think I lack the economic proficiency to really understand this issue. If anyone would like to jump in here, I'm really interested in trying to figure it out. The question of how such a market should be regulated is also fascinating. If you look at their FAQ, InTrade? admits that they don't know the legal status of their market, and allocates the risk of using it to the speculators. I'm guessing this is a reflection of the fact that we do not yet sufficiently understand these young markets enough to create regulatory guidelines.

Hedging Uncertainty

Self-fulfilling Prediction Markets

Prediction Markets for Decisionmaking

Conditional Markets

Market Manipulating

Crazy Science Fiction-y Implications

Perception/Reality

Futarchy and Anarcho-Capitalism

Causal Determinism

Muss es sein?

Predicting/Controlling the Future

Sources

Wolfers Paper: http://www.nber.org/papers/w10504 Times Article: http://www.time.com/time/magazine/article/0,9171,1118373-1,00.html Hanson Theory: http://hanson.gmu.edu/futarchy.html Berg Paper: http://www.springerlink.com/content/u2j52696120vx423/ (Conditional Markets)

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Whoa, this is really interesting. - KateVershov?

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