As we saw in Weird Markets it can be remarkably difficult to pin down the idea of a “market”. Markets are what economists study, economists study markets; a perfectly circular relationship. On the other hand, markets do seem to be a fine way of deciding how to allocate scarce resources: economics is built on this singular, empirical observation.
Given this it’s not a huge jump to recognizing that markets may be a better way of making predictions about all sorts of things than relying on the kind of dubious expert forecasting we've met numerous times as in Forecasting a Financial Earthquake. Prediction markets have suddenly become interesting because they work; which probably means they’ll shortly stop working, because they’re now interesting. Tricky stuff, this reflexivity.
Stockmarkets are the most well known type of prediction market – they aggregate information from multiple sources and combine it all into a single number, the share price. On the whole they do this quite well, notwithstanding the fact that they frequently fail the test of perfect efficiency. Generally, though, they get a lot more things right than wrong.
“People who realize they are not as well informed as average traders tend to stay away. People who do not realize they are not well informed lose and then go away.”
Of course, in stockmarkets this tends not to be true: their sheer popularity almost guarantees an endless pipeline of suckers who confuse and confound valuations and, at times, flood the market with arbitrary signals. But in other, less crowded markets the evidence is that the wisdom of informed crowds works rather well: they recently got the result of the 2012 US Presidential Election almost spot on, albeit the modelling methods of Nate Silver have got rather more attention.
In fact there is a very long history of prediction markets: people were betting on papal elections at the beginning of the sixteenth century and only the threat of excommunication by an annoyed Pope was sufficient to end the practice, in public at least. During the Battle of Britain London brokers ran contests on how many German planes would be shot down each night. Paul Rhode and Koleman Strumpf give a nice overview of the history in
