Even breaks

by Henry on July 6, 2005

Steve Bainbridge makes an interesting argument about prediction markets.

On the one hand, just as Henry Manne justified insider trading in stock markets by arguing that it improved the accuracy of stock market prices, bets by knowledgeable insiders will significantly enhance the predictive power of markets like the TradeSports contracts. Indeed, given the limits on the power of insiders to affect prices in the stock market, the effect is likely to be much stronger in prediction markets, where the ratio of activity by informed traders to that of uninformed ones is likely to be much higher than in stock markets. … On the other hand, in commercial prediction markets like TradeSports contracts, the proprietor of the market presumably has an incentive to eliminate informed insider trading. If there’s a fairly high probability that you’d be betting against somebody with inside information, who thus can’t lose, would you bet? Me neither.

Bainbridge’s argument here reminds me a little of this old post of Dan’s, which argues among other things that Hayek’s notion of the market as a knowledge-creating entity sits rather uneasily with more standard economic arguments such as efficient-market theory. But Bainbridge’s argument is somewhat different and points to a different tradeoff. If you want to use markets to make the best predictions possible on the basis of available information, you’ll want to allow insider trading, which is, by definition, trading by those with valuable hidden information. But this means that you’re likely to lose liquidity by driving out ordinary punters who don’t want to be fleeced by those in the know. And without ordinary punters, insider traders have no incentive to transact (the only reason that they would want to transact is to fleece suckers who know less than they do). The only way in which this contradiction can really be resolved is if there’s a supply of suckers out there, who are willing to make bets against people who are better informed than they are. As Bainbridge points out, this is a condition that can be satisfied. But by and large, it’s only satisfied when people have extraneous reasons to make a bet (they enjoy a flutter). Bets that aren’t “fun,” or otherwise attractive in some way aren’t likely to attract suckers. Thus, they’ll have low liquidity, and not be very useful as a source of information (this seems to be borne out by the empirics; as the authors of this paper note, “as the wonkishness of the contract rises, however, volume and liquidity falls rapidly.”) Thus, even apart from the objections that Dan and John Q. have raised in past posts, prediction markets aren’t likely to be very useful for a very wide variety of important policy issues.

{ 13 comments }

1

SomeCallMeTim 07.06.05 at 8:01 pm

From “dsquared” to “daniel” to “Dan”, all in the time I’ve been reading this blog. The aging process makes me sad.

2

Jonathan Goff 07.06.05 at 8:23 pm

Henry,

I think one interesting thought is that many of the people who think they have valuable information in reality don’t. Ie they think they know how things will go in spite of not having rock solid evidence. Sure people wouldn’t want to bet against someone who actually knows, but how many people actually know that the other person “knows”, and how often do they think that they “know” better?

If that made any sense, enjoy.

~Jon

3

Chris Edmond 07.06.05 at 8:46 pm

Sorry for being slightly off topic, but can I just point out that Dan’s argument “that Hayek’s notion of the market as a knowledge-creating entity sits rather uneasily with more standard economic arguments such as efficient-market theory” is (by now) a very old argument in economics.

Of course, by “very old”, I mean an argument that was published in leading journals (practically) before I was born. In particular, this was a key point in Sanford Grossman’s PhD thesis and in papers by Grossman and Joe Stiglitz.

Some references for anyone seriously interested:

1. “Information and Competitive Price Systems” (with Stiglitz), American Economic Review, 1976.
2. “On the Efficiency of Competitive Stock Markets where Traders Have Diverse Information” J Finance, 1976.
3. “On the Impossibility of Informationally Efficient Markets” (with Stiglitz), American Economic Review, 1980.
4. “An Introduction to the Theory of Rational Expectations under Asymmetric Information” Review of Economic Studies, 1981.

etc etc.

Cheers.

4

JR 07.06.05 at 11:04 pm

It was once possible for a careful bettor to make a steady living playing the horses. Now that the gamblers have moved on to lotteries and slots, the real horseplayers are betting against each other and it’s much harder to come out ahead after the track’s cut. So they are leaving the track as well.

5

dsquared 07.07.05 at 1:43 am

Chris E: “My” argument is a) not the same as the Stiglitz/Grossman asymmetric information one and b) taken directly from FA Hayek, who in turn was writing about it when Stiglitz was in diapers.

6

rea 07.07.05 at 6:35 am

So, it was okay for Pete Rose to bet on the Reds while he was managing them–he was just “significantly enhance the predictive power of markets”?

7

James Surowiecki 07.07.05 at 8:57 am

I think Jonathan Goff’s point is an important one: when it comes to most of the questions that prediction markets would be used to “answer,” lots of people believe they’re fully informed when in fact they’re not. So it isn’t really difficult to get people to trade — as long as the question is interesting, and something about which it’s possible for lots of people to have relevant information. More generally, it’s a mistake to think that it’s clear to people what they actually do and don’t know. On the contrary, it’s very clear that the judgments of the vast majority of individuals are poorly calibrated. This is a bad thing for the individuals, but it’s a good thing for collective decision-making mechanisms like prediction markets, because it means there’s a steady supply of participants.

8

Hayekian_acolyte 07.07.05 at 1:27 pm

Seconding Chris Edmond’s post, I would also add:

“Information, Trade and Common Knowledge”, with N.L. Stokey, 1982, JET (useful for the goff post above, as well as henry’s post)

as well as 20 years of theoretical implementation theory (and 10 years of financial experimental economics) on the informational efficiency of markets, the conditions for when it coincides with allocative efficiency and when it does not etc. For a taste, see here (say)

Journal of Economic Theory 39, 34-58

and here

Journal of Economic Theory 39, 14-33.

Daniel, to modern economists Hayek’s point *only* makes sense as a Stigliztian ‘private information’ model (or ‘asymmetric information’ – although private information is by definition ‘assymetric’). Henry’s original post misses the question of scale relative to market.

Look, you guys need to lose this hang-up about prediction markets: there might be many good reasons not to approve, from a policy perspective, the use of ‘prediction markets’ in certain contexts. That it is not based on sound economics (or is based on putative ‘antinomies’ within economics, and Henry tentatively tries to explore) is not one of them. As well, the policy justification for insider-trader laws, to the extent it *can* be justified, lies with the relationship of managment to the company (fiduciary duties etc), not out of concern for the efficiency of stock markets per se. As with much competition law, lawyers boldly go where economists fear to tread . . . .

9

Villaveces 07.07.05 at 5:12 pm

I remember a company called LTCM. These folks were quite certain they had the ‘inside’ track on investments, and leveraged their investments with what WERE inside loans, by 52x over. It was quite technified, but it demonstrated in the end that no one has perfect information. Smart people often think they have the upper hand, there is no shortage of ‘suckers’, and never will be. Prediction markets will always weigh one prediction against another, and many will disagree or lack the most vital information to making the final decision.

10

Daniel 07.07.05 at 5:19 pm

Daniel, to modern economists Hayek’s point only makes sense as a Stigliztian ‘private information’ model

Well so much the worse for modern economists then. Hayek’s actual point is a lot more subtle and doesn’t rely on the definition of “information” which was foisted on economics by Jon von Neumann after the second world war.

11

joel turnipseed 07.08.05 at 1:51 am

Interesting… a personal note that points up some of the better aspects of the more abstract arguments in this thread made by Jonathan Goff and James Surowiecki (while also pointing up larger hazards of any futures market): I was, for several years, a low-level manager (but one w/lots of cross-product/cross-function visibility into the company) at a mid-cap software company. I left, w/a lot of options unvested even though I had a ridiculously low strike price. Why? The company’s stock price was at around a dollar & I figured a) I could make more starting my own company and b) a lot of other managers, especially in sales, were bailing, too. At the time that I sold my company three years later, the stock price of the company I left for dead was at almost 30. Even now it is at 12. In short, a lot of people who knew everything about the company–from it’s pipeline to its product development portfolio to its customer profiles bailed… and yet the company went on to vastly outperform both our individual and collective opinion on its future. And even on “solid gold” insider information like a sale… who hasn’t seen an M&A go bad (or seen one about to sink suddenly get traction)?

Still and all, I think Henry’s on to something w/his original post: if I knew that, even calibrating for fact that my knowledge as well as that of those whom I knew knew were somewhat fallible, there were people out there gaming the system, I’d be less likely to play (one particular reason why I think we should more tightly regulate investment banks’ M&A activities and disallow VCs/VC investees from serving on corporate boards).

12

nick 07.08.05 at 7:19 am

lots of people believe they’re fully informed when in fact they’re not

More subtly, lots of people believe that they’re better informed than all those other rubes out there. But that’s Charles MacKay (or Charles Kindleberger) territory. Or best left to the arguments between couples over the map on road trips.

Here’s a quick thought: how about a prediction market for Lotto results? I have the nagging sense that you could create one.

13

Brian S. 07.08.05 at 4:52 pm

The difference between “suckers” and “insiders” isn’t no information versus information, but “fragmented bits of generally available information” versus “fragmented bits of restricted information”.

A prediction market where insiders are swamped by suckers will still be helpful in amassing the bits of generally available information in a useful way.

And in any event, I think you could get a market of just insiders – it will operate as long as an individual insiders think their piece of info is better than the collective average. You would bet against other insiders if you’re one of them.

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