Advantages, Observations and Issues about Corporate Prediction Markets
Here's the second part of my notes from the paper, INFORMATION AGGREGATION
MECHANISMS: CONCEPT, DESIGN AND IMPLEMENTATION FOR A SALES FORECASTING PROBLEM,
by Charles R. Plott of CalTech and Kay-Yut Chen of Hewlett Packard
Laboratories,which describes how they set up a prediction market for sales forecasts
at HP.
Advantages of
Prediction Market Over Other Forecasting Methods
·
The methodology is flexible. It can be used to
aggregate any type of information possessed by different people. It involves a
natural methodology for quantifying subjective, qualitative, information and
giving weights to the opinion of different people for the purpose of
information aggregation. The task is performed giving not only a point forecast
but also a complete probability over the range for which the value of some
unknown variable is to be predicted.
·
The methodology is scalable by number of participants,
timing of participants and location of participants. There are no practical
limits to the number of people that can participate. With markets conducted
over the Internet, hundreds and even thousands of people can participate either
at the same time or at different times. Traditionally, businesses collect and
aggregate information through a process of meetings, which not only limits the
number of participants but also the time frame for information collection.
·
The methodology tends to be incentive compatible.
Incentives to hide information, misrepresent information or simply ignore
requests for information are either eliminated or limited. Furthermore the
markets are designed to give incentives to the participants’ to acquire
information about future events and use this information wisely in the market.
Observations
·
Theoretical arbitrage profits existed. In all
the experiments, prices summed to be greater than the winning payoff. However,
to take advantage of the arbitrage conditions, individuals needed to execute
multiple trades when fluctuations of prices were substantial. So it is likely
that there were actually no practical arbitrage opportunities. Why in all 12
experiments was the sum of the prices always above the winning payoff?
·
No significant trends in the sequences of
predictions are observed. So it doesn’t appear there was any response to
changing market information during the trading. Maybe all the information
aggregated quickly at the beginning.
Scientific issues
·
How is the performance of the system related to
the psychology and decision biases of individuals?
·
How can one deal with incentive problems in
which individuals might large incentives to conceal or misrepresent what they
know?
·
What rules and mechanisms might be needed for
different underlying information structures?
·
If markets are thin or the number of
participants few, how will the performance of the system be affected?
·
How can we find the people with the relevant
information and how do we know that they knew something of relevance anyway? If the participants know nothing, the mechanism
will produce nothing.
·
Can a prediction market not only produce a prediction but
also simultaneously help management ascertain which participants have
information. That is, can it be designed to attract those with good information
and discourage those with bad information?
Scientific Literature
The
experimental demonstration is first found in Plott and Sunder (1982, 1988).
This early paper demonstrated that the ability of markets to aggregate
information is sensitive to the market architecture. In particular, this early
work demonstrated that compound securities are not as reliable as indicators as
a complete set of state dependent instruments. The conditions under which a
single compound security is reliable are isolated in Forsythe and Lundholm
(1990) The need for selecting proper instruments is underlined by demonstrations
of markets that can equilibrate at patterns that are not fully revealing of information
such as cascades (Anderson and Holt, 1997; Hung and Plott, 2001) or misleading
such as mirages (Camerer and Wiegelt, 1991) or bubbles ( Smith et al, 1988;
King et al. 1993; Porter and Smith, 994; Lei et al, 2001). In fact, some types
of market organization facilitate no information aggregation at all as is the
case of the winners curse in sealed bid auction markets (Kagel and Levin, 1986;
Lind and Plott, 1991). See Sunder (1995) for a summary, or aspects of search
(Sunder, 1992).
