Should Prediction Markets be Charities?

Advocates of prediction markets often focus their attention on markets that can be run for profit. This may be due to a bias resulting from the fact the prediction markets mainly interest people who are trying to combat prejudices against profit-oriented activities.
Profits are often better measurements of whether something is valuable than the average person realizes, but there is little reason to believe this applies to public goods. And much of the motivation behind prediction markets advocacy is the need to make better information available to voters about the effects of policy choices. That information is about as clear an example of a public good as one can get.
An assumption that a for-profit corporation is the best way to produce a public good should normally be treated with some suspicion (although alternative types of institutions deserve suspicion as well).

A for-profit prediction market that tries to both maximize profits and provide valuable information to voters faces conflicting pressures, since my observations of existing markets such as those on Intrade show little evidence of a significant correlation between the issues that create profitable trading volume and the issues on which a democracy needs more knowledge. If maximizing profit doesn’t provide useful evidence that the company is achieving its goal, then it’s unclear why we should think that a profit-oriented form is the best way to achieve that goal.
Automated market makers that transfer money to traders seem to be a promising way to improve the accuracy of market prices, but seem inconsistent with a profit-oriented goal. They look more like an act of charity than a business practice when the goal is to inform voters.
Prediction markets face significant regulatory uncertainties, and governments are typically more lenient about regulating charities than profit-oriented companies. This may help nonprofit prediction markets both because a nonprofit will have less incentive to pressure traders to make unwise or unfair trades (i.e. the concerns behind gambling laws and laws mandating disclosure will be somewhat weaker), and because a nonprofit is less likely to encroach on the businesses provided by existing financial exchanges.
What many of us want from prediction markets bears more resemblance to the products of think-tanks than it does to any other institution that I’m aware of, and the basic ideas behind such uses of prediction markets are accepted by enough people that we can hope some wealthy donors would contribute to a charity that funds such markets. So it seems natural to me that we ought to focus a significant fraction of the thought about how to implement prediction markets into how to create a charitable organization for that purpose or persuade an existing think-tank to adopt that purpose.

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  • Perry E. Metzger

    Peter says: “A for-profit prediction market that tries to both maximize profits and provide valuable information to voters faces conflicting pressures, since my observations of existing markets such as those on Intrade show little evidence of a significant correlation between the issues that create profitable trading volume and the issues on which a democracy needs more knowledge. If maximizing profit doesn’t provide useful evidence that the company is achieving its goal, then it’s unclear why we should think that a profit-oriented form is the best way to achieve that goal.”

    I don’t see why we think we, as people who don’t have “skin in the game”, think we know what are the most valuable markets here.

    First of all, markets depend on volume. The cost of setting up a new contract on an exchange like TradeSports is minimal, so if a contract isn’t trading, we can assume that either the market operators haven’t thought of it, or there just isn’t enough volume to make the market useful. Without the volume, why do you imagine you will get information out of the market prices? If there is enough volume, there is profit to be made anyway.

    Second, trading in “idea futures” inevitably has a number of motives, but the most important motive for someone trading from the point of view of those who want information out of the market is the profit motive. That is unclearly phrased, so let me try explaining slightly differently. If you want information out of an information market, you want to know that the people who are trading are doing so in as unbiased a way as possible — the greater the extent to which traders are trading purely for monetary reasons, the greater the chance that they’re not going to allow their biases to interfere with their work, and thus the greater the chance that they’re revealing something previously unknown to an observer of the market.

    Continuing on this point, the only way people will have sufficient monetary incentive to work hard on policing their bets in such a market is if there is sufficient volume. We aren’t going to get interesting new facts, I suspect, out of a market that has fifteen academics betting $20 in it. We’re much more likely to see serious research and effort devoted if a bet in the market is a $20,000,000 hedge. If a market can sink a $20,000,000 bet used to hedge, say, the price of a stock that would be damaged if the bet came true, said market is more than large enough to be profitable for the people running the exchange.

    Thus, I don’t see why we need “public interest” exchanges to deal with “unprofitable” contracts when the contracts that are going to yield useful information are going to be quite liquid and profitable for all concerned anyway.

    I have to add that I think that the profit oriented organizations, like TradeSports, have done far more for “proposition trading” than those of us with an academic interest in this. The profit oriented exchanges have strong incentives to build volume after all, and have done so. “Public interest” ideas futures markets will not have such an incentive driving them — the people running them will not share financially in the success of their market, so they will not be as strongly motivated as those who own for profit exchanges.

    Lastly, let me argue against a proposition you advanced — that idea markets are of serious interest because they can help “democracies”. They can’t help democracies make better decisions. Democratic regimes routinely ignore all sorts of useful information merely because said information supports politically unpopular positions. Democracies blissfully ignore the benefits of free trade, implement minimum wages, regulate businesses to death, etc. The information on all of those problems is well known and established, and yet democracies pay it no heed at all and continue doing what is politically expedient. I doubt idea futures are going to yield solid information for policymakers because I doubt that policy makers pay attention to solid information. They pay attention to polling data instead.

    If you truly wish to make democratic states a viable means of ordering legal systems, you will have to first find a way to get them to pay attention to well understood economic theory. If you can first do that, then worry about gathering information from idea exchanges.

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    The technology is being advanced at the moment mostly by for-profit organizations, either appealing to trader preferences for fun, or subsidizing the answering of questions that are primarily of interest to one organization. But I’d love to see non-profit markets, if patrons can be found to pay for them.

    Perry is right that a key question is whether market estimates will be more believed than other sources that are ignored. It could go either way, as far as I can see.

  • http://profile.typekey.com/halfinney/ Hal Finney

    How about government-run markets? The Policy Analysis Market ( http://en.wikipedia.org/wiki/Policy_Analysis_Market ) was shut down before it even started, but maybe a market on less controversial issues could be a success. Governments run both elections and lotteries; in some ways an Idea Futures market can be seen as a little of both.

  • http://gondwanaland.com/mlog/ Mike Linksvayer

    An exchange’s for profit (or not) status is orthogonal to both trader motivation (I agree with Perry regarding the latter — better if traders have purely pecuniary motives) and subsidy — an information seeking entity could subsidize contracts on a for profit exchange. But I wonder if a nonprofit exchange would have an easier time with regulators. Seems a path worth attempting in parallel with for-profit ventures.

    I doubt prediction markets will radically improve democratic decisionmaking but think Perry is too cynical on the matter. Prediction markets havpotentially have at least two related advantages over other sources of information. First, prices converge to a single consensus regarding probable outcomes, whereas there is never a public consensus on policy impacts, even where experts in the relevant field generally agree. Relatedly, one can always find a heterodox expert that will, for example, claim that a minimum wage increase will increase employment. The market consensus is something more readily understood and less easily dismissed than expert consensus.

  • Perry E. Metzger

    I have to disagree with Mike. Just as one can always find a heterodox “expert” who claims minimum wages raise employment, the enemies of a proposal will just find heterodox “experts” and claim this “bizarre idea of a bunch of gamblers deciding policy” is a bad thing.

    Mike seems to think that “market consensus is something more readily understood and less easily dismissed” — I have to completely disagree. Most people do not understand markets at all. They understand them so poorly, in fact, that a large fraction of the population sees no difference between the equities market and a casino. They understand them so poorly that they think of people who raise prices on generators after a hurricane as evil rather than simply participating in the efficient allocation of resources. The average person will not understand prediction markets at all, just as they don’t understand the price of gasoline.

    I will point out that certain people in this conversation have personal experience with how poorly the public understands prediction markets and how much they can get ridiculed — see a certain market designed to predict the results of policy decisions on terrorism for example.

  • http://riskmarkets.blogspot.com/ Jason Ruspini

    Yes, IEM hasn’t had a problem for over fifteen years. The next such exchange would likely face greater challenges, but it’s the legal costs more than the legal risks that have stopped people so far. For one thing, a non-profit status would often absolve aggravated/felony gambling charges, and would count as social gambling in many states. The exchange could also block access from states that seemed hostile or where internet gambling was clearly illegal. And this leaves aside the question of whether a skill-based prediction market is even gambling, which could probably be won with sufficient legal firepower.

    Not charging trading fees would lead to greater liquidity and more accurate prices. A lack of fees might also be logical in some hedging markets. For example, should dispersed interests hedging against the continuation of some industry subsidy be charged trading fees?

  • Perry E. Metzger

    To John Ruspini:

    With respect, IEM is not the place that idea futures etc. are actually being traded. TradeSports and similar internet betting markets are the place that most of the volume happens.

    (I agree that currently such markets are not really legal under US law though they operate anyway. IMHO, the right thing to do is to legalize them, but that’s another story altogether.)

    IEM had practically zero volume in the last US election cycle betting compared to TradeSports. IEM isn’t worth looking at even for academic data — if you want to study the question, get a TradeSports data feed and write appropriate software. TradeSports isn’t very big compared to, say, the New York Mercantile Exchange, but it is plenty big enough to sink bets that are quite substantially sized from a personal (though not a business) viewpoint.

  • http://riskmarkets.blogspot.com/ Jason Ruspini

    While the scale of trading activity may be a factor in gambling law enforcement and regulatory intervention, citing IEM’s low volume isn’t very relevant to the possibility of another non-profit real-money exchange, especially one dealing in the types of technical claims that many are interested in.

    I share the “the public is so woefully ignorant about economics” axe, but this is mainly an obstacle to publicly-funded markets.

  • http://gondwanaland.com/mlog/ Mike Linksvayer

    Yes, people badly misunderstand markets. I have a very poor understanding of equity markets and can’t make heads or tails of equity prices. But equity markets, energy markets, any markets excepting prediction markets, are not designed to produce easily interpretable information. All I want to claim is that people have a better grasp of odds than even incredibly simple theory, e.g., the law of demand.

    And yes, you’ll always be able to find someone who claims that prediction markets are nuts. But there again, the the truth of this claim is easy to evaluate relative to others.

    At the end of Perry’s first comment he implies economic education must precede prediction markets having any policy impact. But what incentive is there to pursue economic education? Why, better to profit from participation in policy markets, of course. 🙂

  • http://profile.typekey.com/bayesian/ Peter McCluskey

    Mike, thank you for the idea of a charity that subsidizes contracts in an exchange it doesn’t run. That would simplify some problems. I can’t tell whether it makes the legal risks better or worse if the charity deals with a for-profit exchange. If the charity were to subsidize contracts on IEM, that would reduce many of the legal uncertainties, at the possibly acceptable cost of limiting how much money a trader could risk.

    Hal, the people in government with enough authority to implement more than token experiments seem much less open to the idea than do patrons who got rich in tech startups. But if you think you can convince some part of the government, I encourage you to try.

    Perry, if your simplistic stereotype of democracy is accurate, then it certainly follows that this whole discussion is pointless.
    You ask “Without the volume, why do you imagine you will get information out of the market prices?”
    Part of the answer is the increased incentives provided by the automated market maker. See for instance Ledyard’s paper in Information Markets: A New Way of Making Decisions by Robert Hahn (online at http://www.aei-brookings.org/publications/abstract.php?pid=1058).
    You might be right that the markets I have in mind won’t induce much research (it probably depends on how well funded the automated market makers are). I’ll be quite satisfied if they merely cause more accurate evaluation of existing knowledge.

  • Perry E. Metzger

    Peter says: “Perry, if your simplistic stereotype of democracy is accurate, then it certainly follows that this whole discussion is pointless.”

    No, it isn’t pointless. There are a great many ways that such markets can help the world — by providing hedging and insurance, by giving information to private parties, etc. It is just that idea futures don’t appear to be that useful for fixing the policies of governments.

    By the way, I take great exception with your calling my opinion of the value of information to democracy “simplistic”. Perhaps it is an unpleasant opinion, but I don’t see much reason to think of it as wrong. It is easy to call an unpleasant opinion “simplistic” but it is much harder to show what is wrong with it. Would you care to back your characterization up with actual argument?

  • http://profile.typekey.com/halfinney/ Hal Finney

    There exist examples of prediction market prices which are widely used, accepted and reasonably well understood. Every time the news announcer says, “The price of oil rose two dollars today on fears of middle east unrest”, he is quoting the result of a prediction market. There’s no reason he couldn’t say, “The odds of President Bush’s impeachment rose 10% today after a new round of cricism of the president’s policies.” In fact I noted the betting markets being mentioned quite a bit this past election cycle, not quite yet hitting the major media but often mentioned in blogs and occasionally in newspaper articles.

    Here’s a cool idea: imagine if the Democratic or Republican parties ran their own prediction markets to see who among their main candidates has the best odds of winning the 2008 presidential election? It could help the party by reducing the impact of extremists in the early days of the election and giving candidates a boost who have the best chance in the fall primary.

  • Perry E. Metzger

    One last point: I will note that, in spite of the amount of money riding on this last election, the market on TradeSports was leaning heavily against the Democrats taking the Senate almost until the end. In other words, the prediction market was wrong. I’ve seen the markets fail in other instances, too.

    One assumption we have made throughout this entire discussion is that prediction markets are high quality sources of information. We don’t actually know that. We have been assuming that.

    I would argue that, in fact, they are at best good quality ways of combining current available information, and even then only assuming the Efficient Market Hypothesis is true, and I have my doubts that the EMH is more than “largely” true.

    The markets may be able to tell me what “we all know”, but I suspect they aren’t very good at telling us what no one knows, and that is often much more important. They are also not very good at telling you when they are combining good information versus when they are just combining everyone’s bad information — it is not obvious how to distinguish an interesting prediction from mere combination of lots of limited (and incorrect) information. We need a lot more studies, preferably with data from the fairly large betting markets that now exist.