Prediction Markets

We’ve discussed how prices are signals that convey information about goods — but can prices also convey information about events and even predict the future? For instance, can we predict Middle East politics based on the price of oil futures? Or predict the consequences of climate change based on the price of flood insurance in coastal cities? Of course, prices in these examples are imperfect predictors as there are many factors that influence the price.

We also take a look at some markets that have been designed to make predictions, like the Iowa Electronic Markets, and a specific example of how it was used to predict the outcome of the 2008 presidential election between John McCain and Barack Obama. What about the Hollywood Stock Exchange, where traders buy and sell shares and options in movies and music? What did the studio learn about its casting choices for the film, “50 Shades of Grey”? We discuss these examples and more in this video.

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- [Tyler] Today, we look
at a new type of market.

A market which has been designed
to make predictions.

In previous talks we discussed
how prices are signals

that convey information.

Information about where goods
have high value

and where they have low value,
which goods have high value

and which have low value
and so forth.

Prices also can convey information
about world events,

even predictions of the future.

So, the orange juice futures price
for instance, implicitly contains

a prediction
about the weather in Florida.

It's not that these markets
were designed for this purpose,

rather it's that speculators,
if they are to profit

from movements in the price
of orange juice futures,

have to make some predictions
about the weather in Florida.

They have to know something
about the weather in Florida.

So the price
of the orange juice futures,

comes in part to reflect
the information that speculators

hold about future weather
patterns in Florida.

Indeed, economists and others
often have looked informally

to market prices
to help make predictions.

To help predict Florida weather,
they look to the price

of orange juice
in the futures market.

To help predict
Middle Eastern politics,

they look to the price
of oil and oil futures.

To help predict the consequences
of global climate change,

they look to the price
of flood insurance

in coastal regions.

Now, in each of these cases,
the implicit prediction

is just a by-product of the market
and indeed many other things

are going on in these markets
which also influence the prices.

The prices in these markets
are noisy predictors.

They're rather imperfect predictors
because they weren't designed

to only predict.

What would happen if we design
the market explicitly

to make predictions?

Then the predictions we got
out of the market

might be even more robust
and even more accurate.

Let's take a look at some markets
which have been designed

to make predictions.

Prediction markets
are speculative markets

which have been designed
so that the prices

can be interpreted as probabilities
and used to make predictions.

One of the most famous of these
is the Iowa Electronic Markets.

I encourage you to go
to the web and check them out.

Traders on the Iowa Electronic
Markets buy and sell shares

of political candidates,
and the prices of the shares

can be used to predict
the outcomes of elections.

Let me give you an example.

Here's the case
of the Iowa Electronic Markets

from the 2008 election
between Barack Obama

and John McCain.

In these markets,
one Obama share pays you a dollar

if Obama wins and pays you
nothing otherwise.

One McCain share pays you a dollar
if you hold the share

and McCain wins,
and pays zero if he loses.

Now, suppose you think Obama
has an 80% chance of winning

that election, how much
would you be willing to pay

for an Obama share?

Well, if an Obama share
pays a dollar if Obama wins

and he has an 80% chance
of winning,

then that share is worth 80 cents.

You would be willing to pay
up to 80 cents

for such an Obama share.

Suppose you enter this market
and you find

that these Obama shares
are selling for 65 cents,

well, that's a buying opportunity.

Something which you think
is worth 80 cents

is selling for 65, so then,
you should buy Obama shares.

In buying the shares, you would
be pushing up their price.

In this way, your predictions,
your information, your opinions

about which candidate
is likely to win

become incorporated
into the price of an Obama share.

By the way, suppose you thought
Obama had an 80% chance

of winning but his shares
were selling for 90 cents,

well then, you would want
to sell Obama shares.

Even if you're an Obama supporter,
to make more money

you would sell the Obama shares
and buy the McCain shares.

Again, in this way, prices come
to reflect the information.

There are lots of traders
in these markets.

People who are
very politically astute,

who understand
the electoral college

and who understand
how elections work

and how well or how badly
a campaign is going.

When these individuals
buy and sell shares,

their information comes
to be reflected

in the market prices.

Here are the actual prices
on August 8th, 2008.

Obama shares were selling
for 63 cents per share

and McCain shares
were selling for 37 cents.

The market was predicting
a high likelihood of an Obama win

and in fact, that did, of course,
turn out to be the case.

In over 20 years of testing
these markets,

in presidential elections,
congressional elections,

and state elections,
these market prices

from the Iowa Electronic Markets
have turned out

to be better predictors
of the outcomes

than have political polls.

That makes a lot of sense.
Think about it.

With real money on the line,
people have an incentive

to think carefully
when they're investing

and they have an incentive
to collect and process

and interpret all
of the information

from available all over the world.

The resulting market prices
reflect a lot

of deep-seated information
and indeed interpretation

in a way which political polls
simply cannot.

Similar prediction markets
have been creating

all kinds of things.

Some are pretty trivial things,
such as which actor or actress

is going to win the next Oscar,
but also, firms have begun

experimenting with prediction
markets to help

from forecast variables,
like their future sales

or which is the better decision,
or what will happen

in some particular market
or some particular economy.

Firms have been using
prediction markets

to try to help themselves
make better decisions.

Let's give an example.

At the Hollywood Stock Exchange,
traders buy and sell shares

and options in movies,
music, and Oscar contenders.

Some 800,000 traders
do this for fun.

They're using make-believe
"Hollywood dollars"

but they still care enough
about the outcome

to make the prices in these markets
pretty reliable predictors

of future film profits.

Now, although the traders
are doing this for fun,

the website is owned
and run for profit.

The information,
the implicit predictions

in these prices,
that's valuable to studios

who want to try and understand
what's going to work

in their next film
and what's not going to work.

Here is an example.

Some of us may believe
that sex sells,

but is that actually the case?

Well, on the Hollywood
Stock Exchange,

we can be much more precise
using market prices.

Here is some of the trading
for the movie

"Fifty Shades Of Grey"
and you can see the price

made a whole bunch of leaps
up and then leaps downward.

That's reflecting changing
revenue estimates for the movie.

A leap up came
when Charlie Hunnam was cast

to play the title role in the movie
and then the price did go up.

Later on, Charlie dropped out
and the price dropped

right back down again.

The prices in these markets
are important information

for the studios.

They tell the studios how much
are these actors really worth.

If we hire this actor,
how much will revenue

for the movie go up?

Are people excited
about a particular actress

in a particular role,
what about the director?

By using the information
and the prices

from the Hollywood Stock Exchange,
studios are able to better cast

their movies and they
can make better decisions.

No prediction process
has perfect accuracy,

but the prices from the Hollywood
Stock Exchange

turn out to be pretty useful,
especially when compared

to other methods.

Along here, we have predicted
opening revenues as shown

by the prices on the Hollywood
Stock Exchange,

and then here we have
actual revenues.

If the predicted revenues
always equal the actual,

well then, everything
would be along the red line.

When the actual revenues
turn out to be more

than predicted,
we're above the red line.

So the original movie,
"Kings Of Comedy",

was a smash hit because it did
much better than predicted.

The movie, "The Adventures
of Pluto Nash" with Eddie Murphy,

well that was a disaster.

It did much worse than predicted.

On average however,
the predicted revenues

are pretty good indications

of what the actual revenues
would be.

And again, that's why the studios
look at these market prices

because they are relatively
accurate predictions,

more accurate
than other available measures.

Alright, let's conclude.

Market prices reflect information
and they convey information.

Prices in futures markets,
can signal all kinds of things

such as war in the Middle East,
cold weather in Florida,

or who will win the next election.

Prediction markets
are new types of markets

which have been created
to help businesses, governments,

and scientists
predict future events.

Market prices are good ways

of aggregating dispersed
information

and summarizing that information
in a single key figure, the price.

Thanks.

- [Narrator] If you want
to test yourself,

click Practice Questions,

or if you're ready
to move on, just click Next Video.

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