Posted by: Paul Hewitt | March 9, 2009

Comment on Mercury’s Blog about the Economist Article

I agree, public markets are very different from internal ones.  Most of the public markets suffer from having too small of a “crowd”.  Though several cite thousands of users, few of the individual markets have more than a few actual traders.  As a result, they have to use a MSR or some other form of automated market maker in order to ensure enough liquidity for the market to function at all.  In my opinion, this is simply a workaround to the problem of not having enough traders (let alone their having sufficient diversity).  While a MSR does allow for trading among a small number of traders, the fact that it automatically allows traders to sell out of positions affects the traders’ risk preferences, skewing their “investment” behavior.  Internal markets should (and must) avoid this problem, in order to be successful. 

The software vendors make it sound very easy to set up internal prediction markets.  We should keep in mind that the software is but a tool to be used by the prediction market, which is a tool to be used in corporate decision making.  The software solution is relatively easy (apart from the choice of mechanism).  The hard part is satisfying the necessary conditions (crowd, diversity, independence) for accurate predictions.

Generally, public markets stay open until just before the outcome is revealed.  They provide very little useful predictive value, if any.  Internal markets must reveal their predictions much earlier, if they are to be useful and become more widely used. 

Finally, I believe the corporate world has missed the opportunity to use prediction markets to measure the uncertainty surrounding predictions of key events and conditions (so far, at least).  There is very little literature on the use of prediction markets to measure uncertainty.  I believe this would be a very valuable use of prediction markets in the corporate world.

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