Prediction markets and loss aversion

Bob Murphy left a comment after my MoneyIllusion post on the NGDP prediction market (and David Henderson had a similar question):

In a traditional financial market, people have skin in the game and that helps to yield the “wisdom of crowds” results that work so well in markets, but work poorly in (say) presidential elections.

Are you just saying this is better than what we have now? I.e. it would be better still if true experts could put hundreds of thousands of dollars of their own money if they perceived a large mispricing of the NGDP futures contract, but letting people use this forum is still better than nothing?

I’m sure you get my point but for others: Suppose that instead of having Google stock trade on the open market, instead we let everybody who wanted to play guess on Google’s 2017 profitability. And then at the end of the year we gave $10,000 in prize money to the person whose guess was closest. Surely that procedure wouldn’t be nearly as good as estimate of Google’s profitability as our current system.

I partly agree, but would like to separate out a couple of distinct issues. Consider two betting markets, in each case where people predict whether outcome A or B will occur (such as a two person election contest.):

Market A: People bet $5000, and get back $10,000 if they guess right.
Market B: People bet nothing, and win $10,000 if they guess right.

In market B, people have no “skin in the game”, but in my view they would have just as much incentive to bet wisely as in market A. After all, in market A it’s about whether you will win $5000 or lose $5000. In market B it’s about winning $10,000 or winning zero. In both cases, you are $10,000 better off by making the right prediction.

Research in behavioral economics suggests that many people have “loss aversion”, which cannot be explained by purely “rational” models of behavior. I put ‘rational’ in quotes because economists define the term differently from psychologists (or the average person for that matter.) If there is loss aversion, then market A might motivate more effort into searching out the truth.

I think Bob’s more important point is that in a normal market a trader can invest a lot of money and earn large profits if their predictions are more accurate than the consensus. He’s right that the sums involved here (while they will end up being much more than $10,000–I’ll announce a big gift very soon) are too small to interest big Wall Street traders.

Of course it’s much harder to set up a true futures market. For instance, I’d have to go through the difficult process of getting SEC approval, with no guarantee of success.

And don’t write off the usefulness of simple prediction markets. Research by Robin Hanson, Justin Wolfers and others shows that these markets can be surprisingly efficient.

Emile Servan-Schreiber left a helpful comment in response to Bob over at my MoneyIllusion post. Here it is:

There is actually very little data to back-up the idea that real-money markets make better forecasts than play-money market, but there is a lot of data to the contrary. One significant advantage of play-money markets is that they correlate much better wealth and past prediction accuracy. In forecasting the highest-impact recent political events in the U.K., U.S., and France, Hypermind systematically outperformed real-money markets such as IEM, PredictIt and Betfair. Even among real-money markets, those that are most regulated and constrained – IEM and PredictIt – tended to make better predictions than the largest, deepest, least constrained Betfair… Hypermind has been carefully designed to attract and retain only the most dedicated “superforecasters”, and it has an enviable track record of accuracy.

PS. Speaking of predicting the future, how can I resist this great picture: