Prediction Markets

aje on January 20, 2020

Case: Coles, Peter, Lakhani, Karim and McAfee, Andrew, “Prediction Markets at Google” Harvard Business School Case No. 9-607-088, August 20, 2007

Case preparation: “Prediction Markets”, February 2016

Textbook Reading: Chapter 4 (Section 4.5; pp. 127-134)

I am Facebook friends with someone who used to work at Google – here’s a photo of one of the T-shirts:

The Google case was published in 2007 and was accompanied by a lot of interest in prediction markets. In 2021 they launched a new internal prediction market because of two main reasons:

  1. Even more Google employees (i.e. a bigger crowd)
  2. Better technology in the form of Google cloud

I am an academic not an entrepreneur, but if there’s one area that I think is ripe for a successful venture it’s creating the go to prediction market. By the early 2000s we had established that prediction markets were an effective tool for corporate management, and we also learnt how useful they could be for a broad range of policy issues. It’s a scandal that governments – and the US in particular – have been so opposed to their use. (The reason is that they’re treated either as gambling firms or futures traders which are two of the most targeted and heavily regulated and industries). According to Scott Alexander:

There ought to be a billion dollar prediction market, maybe a ten billion dollar one. Smart VCs clearly believe something like this, or Kalshi wouldn’t have gotten $30 million+ in investment. Sometimes people who incorrectly believe I know things about prediction markets ask me if know the missing secret sauce. I don’t think there’s any secret. A prediction market will strike it big when it gets three things right at the same time:

    • Real money
    • Easy to use
    • Easy to create your own subsidized markets

It’s a dream of mine that I may have students who manage to put those things together, solve the regulatory issues, and launch a killer app. So far the closest is probably Polymarket but also see Kalshi and Prediki. Here is a website that aggregates prediction market data:

That said, Michael Story is a superforecaster and has made some important criticisms of prediction markets. See here. In his thoughts on the 2024 US Presidential election, Martin Sandbu argues that:

“A nearly 50-50 “prediction” says nothing at all — or nothing more than “we don’t know anything” about who will win in language pretending to say the opposite.”

The following seems to be a really important point:

“For something to count as a prediction, it has to be falsifiable, and probability distributions can’t be falsified by a single event.”

Perhaps the best attempt to explain the failure of predictions markets to gain traction is here:

They define prediction markets as “contracts that trade on the outcome of future events” and split traders into three types:

  • Savers: people who want to increase their wealth
  • Gamblers: people who want excitement
  • Sharps: people who attempt to profit from better quality analysis

They argue that “most things we might want to know about the future aren’t much fun to bet on”, and this results in a lack of demand: “without savers or gamblers to add volume to the market, the market cannot attract enough sharps to create the liquidity to drive prices toward accuracy.” I am not so pessimistic about the potential for prediction markets, but recognise that in order to work they must:

  • Have short time horizons
  • Be as fun as possible
  • Be subsidised

Here are a couple of op-eds on the benefits of insider trading:

Here is a New York Post article explaining how Nancy Pelosi (and her husband) have benefitted from trading off the stocks of companies that she regulates, and why she is resisting efforts to stop Congressional lawmakers from being able to continue to do so. You can track her trades here. Here is a funny halloween costume.

To read more about the “Policy Analysis Market” (PAM) which was designed by Robin Hanson as a tool for the US Department of Defense, but got cancelled in July 29th 2003 having been described as a “terrorism futures market” by the Washington Post, see:

The Climate Risk and Uncertainty Collective Intelligence Aggregation Laboratory (CRUCIAL) uses prediction markets to learn more about future climate related challenges. See:

Or this video:

 

Finally, for more about the management failure that led to the Challenger disaster, see:

Recommended reading
Recommended video

Recommended audio

“Why There Aren’t So Many Hotel Fires Anymore” Stuff You Should Know.

Points to consider:

    • Key technology = fire doors, sprinklers, and alarms that anyone can set off. Imagine how many major hotel fires would occur if staff had to wait to inform senior management before receiving authorisation to call the fire brigade.
Learning Objectives: Understand how to operate a prediction market.

Internal markets

aje on January 20, 2020

Case: Wessen, R.R. and Porter, D., “The Cassini Resource Exchange” Ask Magazine 16, Fall 2007, p. 14-18

Textbook Reading: Chapter 4 (Section 4.5; pp. 127-134)

For more on the Cassini mission, see here: https://science.nasa.gov/mission/cassini/

Watch Cassini’s grand finale:

I find it a real shame that for many years I’ve been opening students eyes to the economic benefits of utilising internal pricing between different business units, but almost all attention to “transfer pricing” in the last 10 years or so is in terms of tax avoidance (and therefore something to be discouraged). In terms of useful cases, the most relevant ones from HBR are all pretty old, although Knowledge at Wharton have an interview that covers IBM’s utilisation of transfer pricing.

In terms of metrics, I like this warning from Jeff Bezos:

“Somebody a long time ago invented that metric… [and] they had a reason why they chose that… but that metric is the proxy… And then fast forward 5 years… and a kind of inertia can set in, and you forget the truth behind why you were watching that metric in the first place, and the world shifts a little, and now that proxy isn’t as valuable as it used to be, or it’s missing something, and you have to be on alert for that and know ‘I don’t really care about this metric.. and this metric is only worth putting energy into, and following and improving and scrutinizing only in so much as it actually affects [what I care about]’. [You have to be on guard against] managing metrics that you don’t really understand, you don’t know why they exist, and the world may have shifted out from under them a little and the metrics are no longer as relevant as they were.”

Learning Objectives: Think creatively about how to use markets within organisations

Signalling

aje on January 20, 2020

Reading: Spence, M., 1973, “Job Market Signaling”. Quarterly Journal of Economics 87(3):355–374
Lecture handout: Signalling*

Textbook Reading: Chapter 3 (Section 3.4; pp. 90-96)

Here’s a lecture video providing an example of the model.

Here’s my treatment of signalling and countersignalling:

And here is a great twitter thread on why you should always wear a tie with a formal suit:

https://twitter.com/dieworkwear/status/1776148941278781833

In “What toffs and plebs share“, Ed West uses the signalling vs. counter signalling distinction to argue that institutions such as horse racing or the army demonstrate a unity of peasant culture and aristocracy. He identifies a U-curve of social patterns, with those in the middle trying hard to distinguish themselves from those below, even though this reduces their ability to mix with those at the top.

A good book (that I haven’t read yet) that uncovers how deeply social status affects human action, see:

Recommended audio:

Recommended video:

This debate considers the extent to which higher education is merely signalling:

Learning Objectives: Understand the returns to education

Focus on diversity: Claudia Goldin is a world leading labour economist, a former president of the American Economic Association, and co-author of a highly influential book on the earnings gap between high skilled and low skilled workers. She is also a pioneer for studying the role of women in the economy and won the Nobel Prize in 2023. See here for a video profile.

 

Adverse Selection

aje on January 20, 2020

Reading: Akerlof, G.A., 1970, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism“. Quarterly Journal of Economics 84(3):488–500 (£)

Textbook Reading: Chapter 3 (Section 3.4; pp. 90-96)

Instructor resource:

  • “Lemons Buyer”, February 2012
  • “Lemons Seller”, February 2012
  • If you are a bit daunted by an academic article, George Akerlof wrote a very interesting essay on how he came up with the ideas and the process of working on the topic. You can read it at the Nobel site.
  • Further reading: “Secrets and agents“, The Economist, July 23rd 2016

Here’s a good video explaining the lemons problem:

Here is an excellent 3 minute video with advice on buying a used car:

Learning Objectives: Think critically about the role of asymmetric information on market performance

Cutting edge theory: Product heterogeneity and customisation

Focus on diversity: Amy Finkelstein, of MIT, was featured by The Economists 2008 list of emerging economists for her work on asymmetric information in health insurance. She won the John Bates Clark medal in 2012.

Spotlight on sustainability: Importance of long term reputational effects of short term strategic choices

Capital Theory

aje on January 20, 2020

Lecture handout: Capital theory*

Textbook Reading: Chapter 6 (pp.165-197)

There is still a website containing the “Millennium Dome Collection”, but this Guardian article provides a thorough retrospective. Here is a lovely list of repurposed American gas stations.

Here is the video of the Sinclair C5 Infomercial:

For more on business plan ecology, see

For a book length treatment of the concept of intangible capital see:

The lesson for economic policy in a world of intangibles is to invest in “knowledge infrastructure”, i.e.

  • Education
  • ICT
  • Urban planning
  • Public science

For a nice attempt to avoid treating intangibles as a residual, or less clear category and a meaningful attempt to conceptualise and study them see:

  • Crouzet, Nicolas, Janice C. Eberly, Andrea L. Eisfeldt, and Dimitris Papanikolaou. 2022. “The Economics of Intangible Capital.” Journal of Economic Perspectives, 36 (3): 29-52.

They argue that intangibles require a storage medium, where “The medium can be a piece of physical capital, like a computer (for software), or a document (for a patent or a design), or a person (for a method or an innovation).” This need for a storage medium implies two things:

  1. Non-rivalry in use
  2. Limited excludability

They argue that, “the extent to which these properties generate a valuable intangible asset— which motivates investment—depends on the properties of the storage technology, and the resulting non-rivalry and excludability, and the institutions that enforce property rights.”

The entrepreneurial state

Some people, such as Mariana Mazzacuto, argue that states should be bolder about their role in technological innovation, and that ‘directed planning’ can improve on market outcomes. Here key work is:

  • Mazzucato, M. (2013). The entrepreneurial state. London: Anthem Press.

Mark Pennington has provided a good critique of this view, however. For example:

  • “she ignores the opportunity costs of the spending she claims was partly responsible for innovation and growth”
  • [she] “fails to recognise that those elements of public spending that may have generated benefits were not ‘planned’.” (Indeed they “appear to have been unintended or accidental consequences emerging from essentially random spending in the defence sector”).

In conclusion, “the Mazzucato case for state-based experimentation… is the suggestion that if governments commit to spending enough public money on their favoured projects it would be remarkable if none of this expenditure did any good. Yet, this position hardly amounts to an endorsement of the transformational potential of the state.”

Microclimate

When talking about macroeconomics I think it’s important to distinguish between the overall economy and the circumstances of an individual firm. We can’t always assume that macro conditions are felt the same by each company within it. I explain more in this video:

 

Unemployment and the labour market

This article from the New York Times has a great visualisation of how unemployment is measured.

The most striking fact about labour markets over recent years is the decline in labour force participation across the developed world:

By contrast, labour force participation of women has increased:

Martin Wolf believes this is due to the following main factors:

  • Declining fertility (due to lower infant mortality and, perhaps, seat belt laws)
  • Lower household maintenance costs
  • Declining relevance of physical strength for productive activity
  • Rise of the service economy

But notice how, in the US, the prime-age female participation rate has in fact  fallen from 2000 to 2019. These images are from: Wolf, M., 2023, The crisis of democratic capitalism, Allen Lane, p. 96.

Learning Objectives: To understand what capital goods are

Spotlight on sustainability: Look at instances where resources have been reconfigured for alternate uses

Auctions

aje on January 20, 2020

Case: Hild, M., Dwidevy, A., and Raj, A., 2004, “The Biggest Auction Ever: 3G Licensing in Western Europe”, Darden Business Publishing

Discussion question: What are the alternatives to auctions?

Textbook Reading: Chapter 3 (Intro and Section 3.3; pp. 65-67 and pp.83-89) and Chapter 12 (Section 12.4; pp. 434-437

You can test you knowledge of this session with this quiz.

In this lecture video Tim Roughgarden “provides a detailed case study of the 2016-2017 Federal Communications Commission incentive auction for repurposing wireless spectrum”. It demonstrates how economics, computer science and business can coincide to solve complete real world problems. For a short overview of the success fo spectrum auctions, see here:

In October 2020 Paul Milgrom and Robert Wilson were awarded a Nobel prize for their work on auction theory and design. Tim Harford provided a neat overview of their contribution in the Financial Times. As he says,

A well-designed auction forces bidders to reveal the truth about their own estimate of the prize’s value. At the same time, the auction shares that information with the other bidders. And it sets the price accordingly. It is quite a trick.

Instructor resource: The Biggest Auction Ever: What Happened Next?, February 2019 +

To see my guided tour of the Dutch flower auction in Aalsmeer, see here:

Application

In January 2025 Tim Leunig proposed to fund Heathrow’s expansion by auctioning off landing slots. Apparently a prime morning landing slot can be worth around £78m! His original post is behind a paywall, but more information see this article by Ryan Bourne.

Learning Objectives: To consider how auctions compare to other allocation mechanisms. To understand different types of auction and apply them to real examples.

Cutting edge theory: Auctions are used in e-commerce

Focus on diversity: An expert on applied auction formats, Susan Athey was the first female winner of the John Bates Clark medal. She has been an advisor to Microsoft and you can follow her on Twitter here. 

Spotlight on sustainability: How governments can use beauty contests to mitigate the environmental impact of infrastructure spending

Oligopoly

aje on January 20, 2020

Group activity: Cournot and Bertrand Games, December 2018

The activity is based on Beckman, S. R., 2003, “Cournot and Bertrand games” Journal of Economic Education, Vol.34, No.1, pp.27-35

Textbook Reading: Chapter 5 (Section 5.2; pp. 139-145)

Here is a good example of (potential) tacit collusion

In this Lex Fridman interview with FBI hostage negotiator Chris Voss, Voss calls the word “fair” the f bomb. In his experience,

Nobody uses the word fair when they have got criteria to back them up

Here’s Bart Wilson on the meaning of the word “fair”:

Learning Objectives: Gain experience of iterated prisoner’s dilemmas

Markets in everything

aje on January 20, 2020

Reading: “I’ve got debts, please buy my kidneys” The Times September 27th 2009

Discussion question: What are some different ways in which we could allocate kidneys?

In April 2021 a New Jersey man sued the federal government for the right to sell his own kidneys:

“If the opportunity existed so that I could help out someone in need while helping myself, I might do it,” Bellocchio said.

Bellocchio argues that kidney transplants are low-risk procedures, and notes that you can donate an organ — even though you can’t sell one.

“Altruistic donors are lauded for their selflessness. Their vital role in saving lives is undeniable,” the court papers say.

“However, demand outstrips supply, and there is no valid constitutional or public policy rationale why one should not be able to receive a profit from such a transaction.”

Further reading: Postrel, V., “Here’s Looking at You, Kidney” Texas Monthly, June 2006

The issue of repugnance rests on the claim that the moral status of an activity shouldn’t hinge on whether money changes hands. If something is morally permissible to exchange for free, then people should be allowed to trade. Another way of thinking about this is that the reason slavery was wrong was because of the slavery, not the profits. If someone “donated” a slave, that wouldn’t be ok.

Common rejoinders to markets include things like:

  • Financial compensation commodities the good/service and thus changes our relationship with it. As Peter Jaworski explains in the podcast linked below, we buy and sell dogs and that doesn’t mean we treat them as mere objects.

Consider the case of sulphur dioxide emissions (via McMillan, J., (2002) Reinventing the Bazaar, W.W. Norton & Co. (p.182-187) link), and notice how for many environmental activists the moral objections to trading rights to pollute seemingly outweighed the dramatic progress on reducing harmful pollution. This implies that switching people’s mindset to tolerate market mechanisms could be an incredibly powerful tool to improve the world around us.

The Story of Vaccine CA is a really good example of an urgent allocation problem that cannot be solved by markets or by central planning. It’s an ethnographic and anecdotal account of a 200 day period where tech volunteers got together to alert American’s on where covid shots were available.

Listen:

  • Ep. 2, Peter Jaworski – Should Markets Have Limits? The Curious Task, August 14th 2019 – in this interview Peter Jaworski argues that If it’s morally permissible to donate blood plasma it should be ok to be paid for it. In fact, if we pay companies for plasma bought from Americans, why not pay Canadians? And if every other person involved (doctors, nurses, equipment suppliers, logistics) is being paid, why shouldn’t the person making the donation?
Learning Objectives: Understand the scope and ethical boundaries of markets

Focus on diversity: Virginia Postrel’s decision to donate a kidney, and write about it, provides a personal and inspirational view of the topic.

Platforms

aje on January 20, 2020

Case: Moon, Y., “Uber: Changing The Way The World Moves” Harvard Business School Case No. 316-101, January 2017

Case preparation: Uber, June 2022

Textbook Reading: Chapter 5 (Section 5.3; pp. 145-149)

  • The world’s largest retailer, Alibaba, has no stock
  • The world’s largest taxi company, Uber, owns no cars
  • AirBnB own no hotels
  • Facebook produce little media content

Platforms are dominating an increasing area of the digital landscape and generate revenue through:

  • Subscription fees
  • Commissions
  • The monetization of attention

This case study looks at the effect of Ariana Grande’s sell out concert at Madison Square Garden in 2015. The chart below is fascinating. The red line is a reflection of demand, showing how many people are opening the app (presumably because they are hoping to get a ride). The peak at the end of the concert is obvious and increases by a factor of 4. Ordinarily, one might expect massive increases in wait times and a shortage of drivers. However Uber’s surge pricing algorithm increased the fare which enticed more drivers to be available. This is the green line.

 

The consequence of the increase in supply, to deal with the heightened demand, was an extra minute of wait time but no drop off in the number of completed rides. How amazing!

You can read the full article here:

In 2023 I published an academic article on how cultural economics helps us to categorise and understand new entrants such as Uber. I find that reducing entry barriers and less exclusion are key factors in a dynamic market order. Here is Elizabeth Warren emphasising the distinction between employees and contractors (note: I think she’s wrong):

In this Vanity Fair article, Uber co-founder Travis Kalanick defends surge pricing:

“You want supply to always be full, and you use price to basically either bring more supply on or get more supply off, or get more demand in the system or get some demand out,” he lectures like a professor. “It’s classic Econ 101.”

Don’t forget – waiting in line is just another form of surge pricing:

Another upside of ride sharing apps is a reduction in drink driving. According to one study,

Our results imply that ridesharing has decreased U.S. traffic fatalities by 5.2% in areas where it operates. The annual life-saving benefits are $6.8 billion.

An excellent article on the incentives of platform industries is “The Host’s Dilemma” by Jonathan Barnett. He argues that platform providers face a trade off between being open (and generating users) and regulating access (to monetise).

Recommended reading:

Learning Objectives: Peer-to-peer markets, Ethical implications of disruptive business models

Cutting edge theory: An economic analysis of platforms

Spotlight on sustainability: Employee welfare

CC Simulation

aje on January 20, 2020

Case:

  • CC Simulation, February 2014
  • Discussion question: Is the market for airport services in the UK competitive?

Textbook Reading: Chapter 5 (Section 5.4; pp. 149-159)

Group activity: CC Simulation B, May 2018

You can watch a good introduction to Porter’s 5 forces here. An explanation from Michael Porter himself is here:

And no lecture on the 5 Forces model would be complete without watching Florian Ederer’s take:

Case solution: CC Simulation: The Verdict, October 2014
Group activity: Tollbooth, December 2020
Learning Objectives: Understand how regulators view competition. Create a market entry strategy.

Spotlight on sustainability: Look at the European market for aviation travel and emissions