Share prices and corporate bond prices are often used in corporate finance as indicators of a firm's prospects. These days, however, the idea of markets is expanding beyond the financial world, as Web sites such as InTrade become hosts to prediction markets that let users bet on just about anything.
In fact, some of the most popular markets on InTrade include one in which users predict whether or not a Palestinian state will be established by the end of the year, and one where traders bet on the date al-Qaeda leader Abu Mousab al-Zarqawi will be captured.
Academic institutions are also harnessing similar market techniques to make predictions. University of Iowa researchers are working on a market to guess when the next flu outbreak will occur, while at the University of Miami, a Hurricane Futures Market is in the works.
The logic employed is that prediction markets work because of information aggregation. Since the prediction markets operate with real cash, those who have come across information will have a monetary incentive to participate. The knowledge of such "insider traders" will then be distributed to the masses in the form of a fluctuating price.
The price of each contract on InTrade's site ranges from zero to 100, and represents the percentage probability of an event's occurrence. For example, the ask price - or price at which a contract will be sold - in the Hillary Clinton market was 43.9 as of Tuesday.
One year prior to the 2004 presidential elections, the contract predicting whether or not George W. Bush would be re-elected traded around 63. In other words, 2003 InTrade users believed there was a 63 percent chance Bush would not have to move out of the White House.
Once the incumbent won the election, the price became 100 points. Contract holders who had purchased the stock at 63 received the difference between the closing price and the rate they paid, or 37 points. Each point is worth ten cents of real money.
"Generally, I think following the crowd is the way to bet," said Economics Lecturer Christopher McHugh, who specializes in financial economics. "And people who have money on the line usually do better than experts on discerning trends and turning points."
"Markets are not often 'as good as experts' at predicting - they are usually much better," McHugh added. "Any real economist likes the ideas of information, market forces, prices, etc. demonstrated in this line of research."
"It's certainly true that people who choose to invest in the market will pay more attention to the new information as it comes out," Assistant Political Science Professor Deborah Schildkraut said. "They're likely to be political junkies in the first place, and now they'll also have money on the line. So in that sense they will be more 'sophisticated' than the average voter."
Political Science Professor Kent Portney questioned the accuracy of such markets, however. "The idea of creating a wholly artificial market through the use of betting seems a stretch to me," Portney said.
Though Portney said he believes "there is little doubt that true markets are great for setting prices, and economists have done enormous amounts of research to understand the characteristics of true - and effective - markets," he said. "Whether these pseudo-markets meet that standard is an empirical question."
Portney admits that he has no expertise in such empirical debates, but his "expectation suggests that such markets would end up being poor predictors of the future just the way that Las Vegas does not do a particularly good job at the beginning of the football season in predicting who will win the Super Bowl."
"If prediction is the goal, I would guess that these markets won't work very well," he said.
"True prediction is tough in any case," McHugh said. "Most events in the future are pure guesses, and even collective wisdom doesn't add much."
McHugh also finds flaws in the prediction market system: "Many of the claims of these prediction systems have to be checked," he said.
In a recent Time magazine article, InTrade's communication director Mike Knesevitch pointed out that the contract on Saddam Hussein's capture unexpectedly rose from nine to 30 just two days before his capture. McHugh wondered if "perhaps the turn in the odds on the capture of Saddam Hussein was just a quirk, and maybe similar turns happened but were not reported by the people running the system."
Furthermore, the ability of the markets to be predictors is complicated by the issue that "some of the situations described in the [Time] article are just for fun," McHugh said. "People want to bet on things with the betting as the end in itself." McHugh believes the stock market differs because there, "you have lots of people with lots on the line."
Despite their flaws, certain markets may have some practical purposes because they allow people to hedge risk. "I do think that some of these prediction systems-slash-betting systems will become popular and will help people in the near future to hedge all kinds of events and situations, like employability, that they cannot hedge now," McHugh said.
