Ben Cowling asks,

What do you think of the growing area of ‘expert trading markets’ using expert opinion for predicting future events (as compared to, say, formal mathematical or statistical models incorporating past data in the forecasting process)? From what I can gather the markets produce a form of informative prior so perhaps the whole process might be considered as a kind of simple mathematical model(?)

I’m motivated by the recent article in the economist:

Science and Technology: Trading in flu-tures; Predicting influenza
The Economist: 377 (8448) p. 108. Oct 15, 2005.

But I know these expert markets have been used in other areas; the Iowa Electronic Market is claimed to be good at predicting all sorts of things successfully including elections, which is why I thought you and readers of your blog might be interested.

My response: I first heard of the Iowa markets nearly 15 years ago, when Gary King and I were writing our paper about why pre-election polls vary so much when elections are so predictable. For this paper, all we needed to establish was that elections are predictable, which indeed they are, using state-by-state regression forecasting models (as was done in the 1980s and 1990s by Rosenstone and Campbell, and more recently by Erikson, among others). The Iowa markets also give good forecasts, which isn’t a suprise given that the investors in these markets can use the regression forecasts that are out there.

Basically, my impression is that the prediction markets do a good job at making use of the information and analyses that are already out there—for elections, this includes polls and also the information such as economic indicators and past election results, which are used in good forecasting models. The market doesn’t produce the forecast so much as it motivates investors to find the good forecasts that are already out there.

As an aside, people sometimes talk about a forecasting model, or a prediction market, “outperforming the polls.” This is misleading, because a poll is a snapshot, not a forecast. It makes sense to use polls, even early polls, as an ingredient in a forecast (weighted appropriately, as estimated using linear regression, for example) but not to just use them raw.

P.S. In the comments, Chris points out this interesting article on prediction markets by Wolfers and Zitzewitz.