The phrase The Wisdom of Crowds is the title of a book by James Surowiecki, a staff writer for The New Yorker. In 2004 Surowiecki wrote that large groups of average individuals can predict outcomes with greater precision than smaller groups of experts. Intrade.com is a real-life, functioning demonstration of this claim.

First, a quick refresher. Anyone can start an account on the Intrade web site. You add a modest amount of money to your account using a credit card. Then you go to a specific event/market which predicts some outcome. The outcome is easy to verify, eventually. For example, there is a market for the outcome that President Obama is re-elected as president in 2012. Eventually that outcome will either be yes or no. As I write this on November 12, 2011 the prediction for this event is 52.1%. If I think it is likely that Obama will be re-elected I can buy a share in this event for $5.21. If I am right, and hold on to this share until the election I will receive $10.00 – a profit of $4.79.  If I am wrong, and hold on to the share I lose my $5.21. If others feel optimistic with me the “price” gets bid up.  If events alter my prediction, I can either buy more shares for the positive outcome or sell my shares.

Here is a graph of this particular prediction and how the Intrade investors have evaluated the President’s chances.

Intrade.com - Probability of President Obama being Re-Elected

You can click on the graph to see more information on this prediction. You can see that Intrade investors have gotten more pessimistic about the President’s chances over the last six months. An important thing to note is that anyone can play in this market. It is not a poll of political experts or those horrid talking heads we hear/see on broadcast media.

A Competitive Market

For my microeconomics students this is an example of a special form of a competitive market. There are many sellers (almost 2,000 to date) and an equal number of buyers. They all have approximately the same amount of information (no insider trading advantage in this case.) It is very easy to enter this market, and to leave it. There are few market imperfections – no monopoly, no obvious cartel.  If we assume, like Adam Smith did 240 years ago, that buyers and sellers will act in their own self-interest (making as much money as possible) then the market price will reach an equilibrium. That equilibrium price will change as new information arrives. For example, when Rick Perry forgets which federal agency he wants to close, some people may judge that Obama’s chances of re-election are slightly higher. They will bid the price up from $5.21 (52.1%) to something higher.

As an exercise consider Surowiecki’s claim that this large number of regular investors will more accurately predict the final outcome that a panel of experts.

An example, from the prediction market Intrade:

As of Monday February 11 Intrade markets give Sen. Obama a 70.0 percent chance of being the Democratic Presidential Nominee and a 47 percent chance of winning the election in November. Sen. Clinton has a 30 percent chance of getting the nomination and a 20.4% chance of winning in November.

So, where do these numbers come from? Not from polls, in the way we think of them. Instead people invest real money, betting on the outcomes. Let’s say that after this weekend you are very sure that Sen. Obama will win the nomination. The Intrade market for this prediction is at 70 percent. If you are so sure of the outcome you might rate the likelihood at 80 percent. For you the odds are better than the market indicates and you expect a profit.

So you buy a prediction contract for $7.00 (70 percent points times 10 cents a point.) You can hold onto these contracts until the Democratic nomination is set. If Obama gains the nomination you receive $10 (100 percent chance times ten cents a point) and make $3. If Sen. Clinton wins the nomination your contract receives nothing – you lose your investment. Your purchase, however, adds demand to this market and nudges the equilibrium price upwards. As more people decide to purchase a contract for Obama getting the nomination, the price rises. This continues until no one is willing to buy another contract. The market price reflects the market’s prediction for this event.

You can also sell your contract at any time. Let’s say the price for Sen. Obama rises to 85 and you’re still thinking 80 percent is the best guess. You can sell your contract for $8.50 and earn a $1.50 profit from your initial $7 purchase. The more people who start selling their contracts, the more the equilibrium price will drop.

There are thoughtful academic journal artices on prediction markets. As with any market the greater the number of participants, and the more available information is to everyone the better the market will work. On the other hand, from a political polling perspective, market participants are not a random sample of likely voters. They self-select to participate in the market.

We’ll keep an eye on this prediction market phenomenon and either edit mistakes in this post or add other posts along the way.

Historical side note… As I read more about these I learn that during and prior to WWII there were either no or few scientific polls, including for political purposes. There were, however, thriving markets on Wall Street and elsewhere that operated like today’s prediction markets – just with no help from computers or the Internet. Newspapers would routinely report on the odds reported in these markets, in lieu of the polling results stories we see today.