The Company of Strangers: A Natural History of Economic Life (Revised Edition) by Seabright Paul

Author:Seabright, Paul [Seabright, Paul]
Language: eng
Format: epub
Publisher: Princeton University Press
Published: 2010-05-01T15:00:00+00:00

PRICES AS OPINION POLLS

What may seem mysterious is how prices can come to summarize information in this way. What is the process by which a price, changing in response to the vagaries of many individual decisions to buy and sell, can come to embody information about anything interesting at all?

To see how, make a visit to Iowa Electronic Markets2 in the weeks leading up to an American presidential election. This is a site run by the Henry B. Tippie College of Business at the University of Iowa for the purpose of trading in financial contracts (“stocks”). But unlike most financial contracts, such as those traded on the New York Stock Exchange, many of the contracts here make cash payments that depend on something other than the performance of firms. Here you can buy a contract that pays a dollar if the Republican candidate wins the presidential election, and nothing otherwise (similar contracts are available for the Democratic candidate, and for any independents who may stand). This is known as a “winner-takes-all” contract, in contrast to other contracts that may pay a range of different amounts for different outcomes. As the election approaches, watch the price at which the stock trades. It rises as traders’ estimates of the candidate’s probability of victory improve and falls as they decline. Why? Suppose the current price is fifty cents. Any trader who thinks the Republican has a better-than-even chance of victory will buy, while one who thinks the chance is worse than even will sell. If there are more of the former than the latter, the price will rise until the optimists and pessimists just balance each other out. If news comes in making it more likely that the Republican will win, the price at which they balance will rise. The price of the stock therefore represents the center of the traders’ estimates (actually what statisticians call a median)3 of the probability of victory. The price was correctly predicting a Democratic victory two months before the election of November 2000—I say correctly, because “victory” was defined as gaining the largest number of votes cast, a feat achieved by candidate Al Gore even if this did not suffice to take him to the White House.

As well as a winner-takes-all contract, whose price represents an estimate of the probability of victory, you can also trade contracts that pay a number of cents equal to the candidate’s share of the popular vote. These contracts will therefore trade at a price equal to the traders’ collective best guess about the share of the vote. This is exactly the same information that traditional opinion polls have sought to discover, and the Iowa Electronic Markets have a track record in prediction that most opinion pollsters would envy. Three months before the elections of both 1992 and 1996 the markets were predicting Bill Clinton’s share of the popular vote to within two percentage points of the eventual outcome. And in the 2008 elections the markets had been predicting a roughly four-percentage-point

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