The only thing that is certain about the future is that it is uncertain. Some questions about the future we might want to answer include the following:
- What is the chance the Democrats win the next U.S. presidential election?
- For a manufacturing company, estimate the mean and standard deviation of the number of units sold for each product during the next month? Accurate predictions of future sales of each product will help us cut inventory costs and reduce shortages.
- What is the chance the Patriots win the next Super Bowl?
In this chapter, we will explore how prediction markets can aggregate information from many people and turn that information into surprisingly accurate information about the future. The term wisdom of crowds (popularized by James Surowiecki in his book The Wisdom of Crowds, Doubleday, 2004) is often used to refer to the fact that a sensible aggregation of information from many people usually outperforms purported experts in answering a question or forecasting the uncertain outcome of a future event.
Examples of Trade Contracts
In prediction markets, participants buy and sell contracts, the payoff of which is tied to the outcome of a future event. Then the price of each contract gives us an estimate about an uncertain quantity, such as the probability of an event occurring or the mean or median of the uncertain quantity. Using the outcome of the 2016 U.K. Brexit referendum for illustration purposes, ...