At VOX, David Hendry and James Reade examine the question, “-How should we make economic forecasts?”- Among the ideas discussed is whether prediction markets could be used to improve economic forecasting. Interesting suggestion and seeming to be worthy of additional exploration, but the authors don’-t go too deep here. Instead, they assert that “-prediction markets can be viewed as a form of …- model averaging,”- and then drift into a discussion of forecast averaging. I’-m not sure that forecast averaging is a good way to look at prediction markets.
Here is what they say:
Prediction markets can be viewed as a form of forecast pooling or model averaging, a common forecast technique (Bates and Granger 1969, Hoeting et al 1999 and Stock and Watson 2004). That is, forecasts from different models are combined to produce a single forecast. In prediction markets, each market participant makes a forecast based on his or her own forecasting model, and the market price is some function of each of these individual forecasts.
Since the “-prediction”- implied by a prediction market is set by the marginal transaction, it depends not at all on the distribution of earlier trades, nor on the valuations of parties priced out of the market at the current price.
For example, consider two event markets: in the first 999 contracts trade at $0.50 and the 1000th and final trade is at $0.75- in the second 999 contracts trade at $0.76 and the 1000th and final trade is at $0.75. In the typical interpretation of prediction markets, the event is “-predicted”- to result with a 75 percent probability in both cases. However, averaging among the different predictions doesn’-t get you that result.
(Well, strictly speaking the market price is “-some function”- of the prices –- namely, one in which all trades but the last are weighted zero and the last trade is weighted one. You can call this “-averaging,”- but that isn’-t the most useful explanation of the function.)
I’-m not arguing that forecast averaging might not be a good idea in many situations, just that averaging doesn’-t seem like a good way to explain what a prediction market is doing.
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