Prediction Markets and the Danger of Manipulation

The most frequent critique of my proposal to legalize prediction markets stemmed from fear of manipulation or gaming. A specific concern is that manipulators will choose to skew the markets at the time of some democratic event, such as a vote in Congress. For instance, those who stand to gain from a President’s stimulus package might bid up the conditional markets that show favorable economic indicators should the stimulus pass.

Even before evaluating how likely such manipulation is, it is important to avoid the Nirvana fallacy. In the absence of prediction markets, special interests and ideologues will try to manipulate legislative action by making arguments that falsely claim public benefits for legislation or falsely deny them. Prediction markets at least balance such influence by encouraging those whose motivation is accurately to predict policy consequences.

In any event, manipulation is unlikely to be successful even in the short term when other traders are aware of its dangers, because they will be particularly sensitive to the opportunities for countering manipulation and making a profit. Two economists, Robin Hanson and Ryan Oprea, have provided a formal model to show at those who are trying to manipulate the markets offer higher returns for those who are trying to make accurate predictions. Since manipulators are consciously trying to aim at the wrong price, they become “sheep” who attract “wolves” interested solely in accuracy.

Past experience in electoral markets also suggests that there are limits on the effectiveness of manipulation. Investors in political shares may have an incentive to bid up their candidates’ price in the hopes of skewing the election by persuading voters to get on the bandwagon of the winning candidate. But spikes in electoral prediction markets that presumably represent either manipulation or exuberance on behalf of a candidate are short-lived as counter traders bid the price down.

Government policies that encourage more people to use prediction markets are likely the best way to discourage manipulation, because thicker markets are harder to manipulate. Companies running prediction markets have incentives to create rules that cut down on manipulation. In Accelerating Democracy , I argue that government should also support experiments in prediction markets that try to find designs to restrain manipulation. Prediction markets will not prove perfect, but they are one of the most important innovations of our internet age that would promote a more reasoned politics.