[Michael Abramowicz, guest-blogging, January 30, 2008 at 9:01am] Trackbacks
Manipulation of Prediction Markets:

The most important objection to governmental use of prediction markets is the danger that third parties might manipulate them. If officials deciding whether to expand a highway use a prediction market to forecast traffic in 20 years, road builders might be willing to lose money on the market if in doing so they can change the forecast and influence the public policy debate.

A partial answer is that the stakes of prediction markets (even the heavily subsidized ones I fantasize about) are sufficiently low that transparent attempts at manipulation are unlikely to have much effect. If George Soros announced that he would be willing to risk up to $1 billion to prop up the share of the Democratic candidate on Intrade, hedge funds would gladly take the other side of unjustifiable offers. Maybe arbitrage can't pop a widely recognized stock market or housing bubble, but arbitrage should succeed in individual prediction markets.

The bigger problem is the possibility of hidden attempts at manipulation. If X is bidding up the traffic forecast contract, this may reflect a genuine subjective probability estimate. If so, everyone else should rationally adjust their estimates in the direction of X's trading, especially since X appears confident. Traders will assign some weight to this possibility, and so will not try to move prices all the way back. If X really is manipulating, X will be at least partly successful.

Note, though, that the reason for X's success is that disinterested traders find trades generally to be informative. If I am playing poker, and think that another player has a tell, I might rationally take this into account. Sometimes, the tell is a fake, but I'm better off looking for tells and taking them into account than wearing a blindfold.

Similarly, given a choice of restricting a prediction market to trusted non-manipulators(e.g., government officials), and leaving it open to all, the open market will tend to produce better information, even though manipulation will sometimes be successful. We can improve performance by identifying traders, especially if some earn reputations for accuracy over time.

Nonetheless, if you're unconvinced, or if you think that manipulation might undermine confidence in government, that's no reason to abandon prediction markets altogether. Instead, one can still use them with a small group of trusted players (whether with real or play money). This is still likely to be better than letting just one of these people make a forecast or averaging all of these officials' forecasts.

For a more complete discussion of this issue in Predictocracy, see here. Also, see this article on a model and this article on an experiment showing that manipulators can increase price accuracy by providing extra market liquidity.