Gambling, prediction markets and public policy.

• Author: Paton, David
• Position: Symposium

1. Background

   The recent worldwide increase in gambling and prediction markets, including casinos, sports betting, lotteries, elections, and wagering on financial instruments has stimulated an important debate regarding the public policy implications of these activities. Some critical research questions concern the efficiency of such markets, heterogeneity in risk attitudes among agents engaged in these activities, the factors that influence performance in gambling, and the desirability of using prediction markets.

   Prediction markets are essentially wagering markets created for the purpose of making predictions. The theoretical underpinning for the use of these markets stems from the view that relevant information concerning the likelihood of future events is dispersed among many people (i.e., the crowd), and that prediction markets allow for the aggregation of this information. The design of the incentive mechanism is critical, since people may invest more thought and energy into expressing their opinion when they have a strong incentive to do so. While the effective use of prediction markets has the potential to help forecasts at a macro level, they may also assist corporations in providing a good estimate of, for example, the launch date of a new product. These markets have, for these reasons, generated substantial interest among social scientists, policy makers, and the business community.

   The insights gained have many potentially valuable applications for policy more generally. In particular, quantifiable targets are ideal candidates for operating a trading market. In this context, the value of the information provided by prediction markets will come primarily from the advance warning that managers will be given of weak performance in particular areas. This can help improve resource allocation.

   Prediction markets have been used to provide forecasts of the probability as well as the mean and median outcomes of future events, and these markets have been used to forecast outcomes ranging from vote shares and election outcomes (e.g., Rhode and Strumpf 2004; Wolfers and Zitzewitz 2004; Snowberg, Wolfers, and Zitzewitz 2005), to the probability of meeting project deadlines at Google (Leigh and Wolfers 2007). Prediction markets have also been used to forecast the timing of an outbreak of bird flu (Wang et al. 2009), and more generally in health-related markets (e.g., Polgreen, Nelson, and Newmann 2007). Prediction markets may also be used as a mechanism to help market participants hedge their exposure to risk (e.g., Athanasoulis, Shiller, and Rietz 1999; Shiller 2003).

   However, some researchers have questioned how far prediction markets are able to outperform other means of forecasting (e.g., Erikson and Wlezien 2008). It is also suggested that prediction markets have a number of limitations (e.g., Green, Armstrong, and Graefe 2007). In particular, they may be open to manipulation (e.g., Wolfers and Leigh 2002), though this might actually aid prediction market accuracy (Hanson and Oprea 2009). Again, they may not provide efficient forecasts of low probability events (e.g., Wolfers and Zitzewitz 2004; Smith, Paton, and Vaughan Williams 2006) and may be open to systematic biases, such as optimism bias (Cowgill, Wolfers, and Zitzewitz 2008) and the favorite-longshot bias (e.g., Vaughan Williams and Paton 1997).

   The role and value of prediction markets is one of the key areas of inquiry addressed in this special issue. The other is gambling more generally, and its relationship to public policy. For instance, since gambling is highly taxed, a key research...