[Michael Abramowicz, guest-blogging, January 28, 2008 at 11:34am] Trackbacks
An Intro to Prediction Markets and the Liquidity Problem:

Thanks, Eugene! I am pleased to be a guest conspirator, and I’m looking forward to writing about Predictocracy. I imagine most readers here are familiar with prediction markets, so I’ll start with only a brief explanation of how prediction markets usually work (a longer explanation from my book is here).

In a prediction market, traders can buy and sell contracts that will pay off should a particular event occur. For example, as of this writing, on Intrade.com, you can buy for approximately 58 cents on the dollar a contract that will pay off should Sen. John McCain win the Republican nomination. The current prices at which people are willing to buy and sell McCain shares translate into an estimate that McCain has approximately a 58% chance of being the nominee.

Most of the markets that the book imagines, however, differ in a fundamental way from the Intrade markets. While Intrade charges for its services, the markets that Predictocracy envisions would generally be subsidized by institutions (such as businesses or governments) willing to pay for the estimates that prediction markets produce.

Appropriately administered subsidies would respond to a common criticism of prediction markets: that on non-sexy topics, prediction markets have too little liquidity to be of much use. Even some Intrade markets attract too little attention, at least some of the time, to be useful; consider the current estimate that Imran Kahn has somewhere between a 10% and a 90% chance of being elected Prime Minister of Pakistan.

A subsidy can solve this problem by rewarding individuals who place aggressive offers to buy and sell contracts. This approach, which I describe here, helps reduce the “bid-ask spread,” and thus indirectly increases the incentives of people to develop information and analysis that they might then be able to trade on. An alternative approach, such as Robin Hanson’s “market scoring rule,” is to create an automated market maker that is willing to buy or sell shares at prices based on the current prediction.