Wednesday, May 2, 2012

Those Wacky Prediction Markets

Matt Yglesias flags something goofy over at Intrade: in their WH 2012 market, Barack Obama plus Mitt Romney only adds to 97% percent. If he had poked around, he would have found worse: Romney still has only a 96% chance of winning the Republican nomination.

As Yglesias explains:
[T]he Intrade betting market lacks the amount of liquidity and derivatives instruments that would be necessary to make it simple and worthwhile for an arbitrageur to spot this and take advantage of it. Austin Goolsbee saw it, tweeted about it, then I decided to write a blog post about it. If something like that happened on a really deep and liquid market, some trading algorithm would have long sense made the moves that eliminate the anomaly but it doesn't work on Intrade.
That's correct, and it's a good reason to take Intrade and other such markets with a grain of salt.. However, I'd say overall it's not the main reason.

What the markets should do, if they work well, is give us the wisdom of crowds. This is one reason they might not do that; another is if they are deliberately manipulated by the campaigns (or even by supporters of the candidates). Does that happen? It should, if the cost is low and people believe that manipulation can help a campaign, both of which conditions surely apply to Intrade during presidential nomination contests.

The other question, however, is whether the crowds have any idea of what they're talking about. During GOP WH 2012, I think the answer to that was a resounding "not even close." That is: it seems fairly likely to me that Newt Gingrich having about a 30% of capturing the nomination was in fact what people thought back during the November Newt surge, but it was nuts! Intraders managed to keep Herman Cain below 10%, so that was a somewhat useful correction to some of the hype out there, but overall it seems to me that Intrade did very little to help make sense of the nomination contest while it was going on. What I suspect is that rather than sorting through the pundits and adding other information, what Intrade is doing is just reflecting what the best-known pundits are saying. And that's not really doing anyone any good.


  1. Slightly off topic, but does anyone else miss Matt writing for CAP? He's good focusing just on the economic stuff. But I really enjoyed his unique point of view on politics as a whole.

    1. I agree. I miss the stuff on politics, political culture, and philosophy. I find him much more hit and miss and much less interesting when he's understanding his metier as purely "economics" blogging. The self-conception allows him to indulge his most narrow neoliberal tendencies, which maybe some people agree with, but which are certainly not interesting, in my opinion. His twitter feed occasionally has observations on politics, which in the past would have resulted in full CAP blog posts.

  2. Yglesias' argument is frustrating, because in diagnosing irrationality, it misses a critical difference between intrade and the financial markets: payout profiles.

    To the point at hand: suppose there's a more scandalous Seamus story yet to be revealed, or that the Mormon President, in the final analysis, really is a showstopper, or something similar. With Gingrich out of the race, that scenario conventionally leaves the nomination to Ron Paul, who then gets his roulette wheel shot at the Presidency.

    What are the odds of that? Obviously, very very small. Suppose the 'fair' probability of that is around 0.2%, so that the "Ron Paul winning the Presidency" would be about 0.1%. In the intrade structure, that means a share of Ron Paul for President should go for about a penny.

    This is where Yglesias' diagnosis of irrationality breaks down. For one penny, you buy a chance to win $9.99 (if Ron Paul wins) while only risking one penny (when Ron Paul loses). Leaving aside the particulars of Ron Paul's candidacy, people like that payout profile - so much so that they are willing to bid it up - Ron Paul's Presidential aspirations trade for about $0.20, much higher than their fair value, but reflecting the discrete, highly imbalanced payouts in the intrade structure.

    This also recalls Matt Glassman's post awhile ago noting that horse race bettors are inherently irrational betting on long shots. The same explanation applied there as here. If the true probability of a nag winning a race is 250-1, that's a discrete payout of $249 for your buck (if you win) at a very low cost of $1 (if you lose). That very imbalanced risk/reward ratio causes the bet on the nag to be intrinsically attractive, and thus nags inevitably go off on too-generous odds, as Glassman noted.

    Paul is the nag here, but the scenario for him to win the Presidency is at least conceivable, which is why he goes out at a higher price than fair value would dictate. It isn't liquidity, its the nature of long shots in horse races.

  3. I'm not sold on the idea that a 3% chance that neither Obama nor Romney will win is far too high. Unexpected deaths or ridiculous scandals are possibilities, however remote. We'd be quibbling with tiny probabilities, but I would say there is higher than 1% chance (but probably less than 3%) that someone other than Romney or Obama will take the oath of office next January 20.

  4. Is there a record of political science types going in and making a small fortune speculating on inTrade? If not, why the heck not?


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