Can You Run a Government With Prediction Markets?

There are surely many possible ways to design a system of government. But what about a government in which many important decisions — from legislation to administrative rule making to court decisions — are made through prediction markets?

Such is the long-shot thought experiment behind Predictocracy, Michael Abramowicz's intriguing field guide to the wide and sometimes wild world of prediction-market applications for government and business.

At a basic level, prediction markets operate somewhat like stock markets. In the stock market, the weight of investors' bets drive a company's share prices up or down. In a prediction market, the weight of investors' bets indicate the likelihood of a given event outcome. For example, at prediction markets Web site Intrade, you can bet on the likelihood of the U.S. taking military action against North Korea (currently low) or unemployment hitting 10 percent by December (currently high).

The idea is rather than taking a survey to get the average opinion and relying on the wisdom of crowds, the prediction market identifies the wisdom in crowds because the market only attracts participants who feel confident enough in their predictions that they are willing to put money on the line. Prediction markets give participants a financial incentive to get things right.

"We all know intuitively that often the average person doesn't know much about something," explained Abramowicz, a professor of law at George Washington University. "And there are cases where you want to know what experts think, and who is most genuinely confident."

Prediction markets gained some popularity as a tool for forecasting the presidential election in 2008. But when government officials proposed using such a market – a DARPA program to forecast terrorist activities in the Middle East – negative publicity forced them to abandon the project.

Still, one day a few years back, Abramowicz, skeptical about the efficiency of the current legal system, began wondering whether it would be possible to imagine a market mechanism for conducting adjudication. "I thought about it and said, 'No, you couldn't do it,'" he said. "And then the next morning, I woke up and said, 'Yeah, you could.'"

When he woke up, Abramowicz had an idea: If you set up a market so that individuals had to announce a price and then make a commitment to either buy or sell a contract at that price, all participants would have an incentive to pick a price that they thought others would also announce. In such a way, you could establish a focal point coordination process, a very efficient way to aggregate collective judgment. This is one of the many permutations of the basic prediction market idea throughout the book.