When economists talk about the magic of markets, they're referring to the ability of markets to create, organize, and transmit information. The magic is that this transmission of information allows production, consumption, and exchange without anybody directing it. Think about that in practical terms. Think of the millions of participants, the billions of goods and services produced, and the gazillion (?!) transactions that take place every day in our economy . . . WITHOUT ANYONE BEING IN CHARGE! It happens through markets. How could anybody say that's not magic!
Markets generate and convey information in the form of prices that emerge from the interaction of supply and demand. In turn, individual people use price information to decide how to behave as demanders and suppliers. Consider the market for gasoline. The interaction between consumers' willingness to pay and suppliers' cost of production results in a price. A supplier looks at the price when deciding how much gasoline to produce and offer for sale, and an individual consumer uses the price to decide how much gasoline to purchase.
Another amazing feature of markets is their ability to provide information about the future - or more precisely, about what people expect to happen in the future. Since both demanders and suppliers consider the future when making consumption and production decisions, the market prices their decisions generate also reflect their expectations. Sounds magical, but it's really just common sense. Take our gasoline example: If people expect gas to become relatively scarce in the near future - whether because a war or natural disaster reduces supply or because upcoming summer holidays increase demand - they fill up now. That increases demand, and the price of gas rises. (People living in Florida have recently seen the effect of expectations on prices in the markets for ice, electric generators, chain saws, and plywood!)
The magic works the other direction, too. If we expect gas to be relatively less scarce - whether because the OPEC nations increase output or because back-to-school reduces vacation driving - demand falls. Because we expect that there will be plenty of gas, we don't worry about driving around with only a quarter tank, and the lower demand keeps prices from rising. In either case, the current price of gasoline reflects people's expectations about the availability of gasoline next week.
Futures Markets Reduce Risk
While all market prices reflect expectations to some extent, some markets exist solely for the purpose of pricing transactions people will make in the future. These so-called "futures markets" serve an important role in our economy by helping to reduce risk. Consider, for example, the problem faced by farmers who bear, today, the expense of planting and caring for crops that won't generate income until the harvest. Added to the normal risks of growing crops is the fact that although an individual farmer may be able to predict the yield per acre of her own and her neighbors' fields with some accuracy, she doesn't know about farmers in other counties or states. She has little ability to predict what the supply and demand will be in the market for her crop at end of the growing season, so she can't predict the harvest-time price. Without that knowledge, decisions about how much and what kinds of crops to grow and how to finance the crops are very risky.
Farmers solve this problem by selling many crops in "futures" markets - markets where people contract to trade something in the future at a price determined today. A farmer might offer wheat for sale in April but agree to deliver it in September. Bread companies, knowing they will need grain in the fall, might buy the contract in April to lock in the price and make sure they'll have wheat available in September.
Futures contracts provide strong incentives - the same incentives of self-interest and profit that operate in all markets - for buyers and sellers to use their knowledge and experience to make wise decisions. If the farmer agrees to a price that is too low, she misses out on revenue. If the baker agrees to a price that's too high, he pays more for the grain than he had to.
Futures contracts are widely relied upon to reduce the risk of business operations, not only for wheat, but for a growing and diverse list of products from oil to pork bellies to gold. As futures markets grow, they become increasingly reliable because they process and generate so much information. Millions of contracts and billions of dollars trade hands everyday. The people buying and selling the contracts are those most intimately connected to the production and sale of the products, and they bring their millions of bits of individual knowledge, experience, and expertise to the market. We shouldn't be surprised at the futures markets' seemingly magical ability to "see" the future and get it right.
Futures Markets and Presidential Elections
The magic of futures markets can be applied not just to the prices of commodities, but to almost any event, result, or outcome. Suppose, for example, that I offer you the following contract:
If Ralph Nader wins the popular vote in our state this November, I will pay you a dollar.
If you don't believe that Ralph Nader has any chance to win, will you buy the contract from me? No way! Why would you pay anything if you believe you'll get nothing back?!
But, suppose that you believe Nader can win - maybe because everyone you know is voting for him. You believe, therefore, that you have a chance to get the dollar from me. How much would you pay me for this contract? It depends on how confident you are. If you think there is a 40% chance of a Nader victory, you'd be willing to pay up to 40¢. If he loses, you lose 40¢, but if he wins, you get my dollar and come out 60¢ ahead. On the other hand, if you think Nader has a 65% chance of winning you'd probably be willing to pay up to 65¢.
Now, what about me? For how much would I sell the contract? That depends on my expectations. If I think that Nader will win for sure, I won't sell it for less than $1 because I know that I would have to pay you $1. If I think there is a 40% chance of Ralph Nader winning I'd gladly sell the contract for anything more than 40¢. If you're the buyer who thinks he has a 65% chance, we'd be able to make a deal, and the contract would sell for a price between 40¢ and 65¢.
If we could create a market that traded these contracts and get thousands of people to participate, the price of the contract would quickly come to reflect a lot of voters' thinking, and could therefore predict the actual chances of Ralph Nader winning the popular vote for presidency in our state.
Iowa Electronic Markets Predict the Presidential Election
The idea of using markets to predict political outcomes is more than theory. There actually is a futures market for the U.S. presidency. In 1988, the University of Iowa business school created the Iowa Electronic Market (http://www.biz.uiowa.edu/iem/), where $1 futures contracts are traded for a variety of sporting, entertainment, and political events. The IEM uses real money, so while it's fun, it's also a serious research investigation into the predictive power of markets.
Elbert: You Don't Need a Crystal Ball
David Elbert, August 11, 2004
"Markets aggregate information," said George Neumann of the University of Iowa. "Everybody has a little piece of information, but nobody has the entire picture."
The economics professor should know. He helps run one of oldest predictive
markets around: Iowa Electronic Markets.
The first Iowa Electronic Market was used to predict who would win the
1988 presidential race. One week before the election, the market, which
was based on the buying and selling of futures shares in each candidate,
forecast that George Bush would beat Michael Dukakis, 53.2 percent to
46.8 percent. Bush won with 53.9 percent. . . .
The school uses the markets as a teaching tool, to give students an
insider's look at how futures markets work, and to create real-world
situations that allow researchers to study investor behaviors. . . .
The school provides two types of markets. Some are open to the public, such as the markets that follow elections or interest rate changes. Others are closed markets that are used as teaching tools - for example, the markets that predict gross sales for movies. . . .
The predictive value of futures markets has caught the eye of high-level executives, according to Time.
The magazine said that at least two major companies, Hewlett-Packard and Eli Lilly, are experimenting with internal marketplaces to help predict events.
http://desmoinesregister.com/apps/pbcs.dll/article?AID=/20040811/BUSINESS03/408110316/1032
On the Iowa Electronic Market (IEM), futures contracts pay $1 if a defined outcome occurs - like the winning of a Presidential election. For example, on September 6, 2004, you could buy a George Bush contract in the IEM for 55¢ and a John Kerry contract for 45¢. (Notice that the sum of the contract prices will always be close to $1 since the probability of either Kerry or Bush winning is, realistically, 100%. Sorry, Ralph.)
People who bought Bush contracts on September 6th believed that George Bush had a greater than 55% probability of winning. Those who bought Kerry contracts believed the likelihood of John Kerry winning exceeded 45%. As people buy and sell contracts, the prices respond to the changes in supply and demand. If market participants believe that Kerry's chance of winning is improving, they will sell Bush and buy Kerry. This will cause the price of Bush to fall and the price of Kerry to rise, reflecting the change in expectations.
Polls vs. Markets
Back to our original theme - markets and information. Polls, expert analyses, complex computer models - sometimes it seems we're buried in information and predictions about the election. So what's the most accurate, and how do futures markets compare to other predictors? By now you shouldn't be surprised to learn that "Markets Rule!"
Election Time: What Are the Odds?
Joanna Glasner, Oct 16, 2002
People who criticize politicians for paying too much attention to the polls may have a point.
According to online wagering sites, would-be public servants could've predicted election outcomes a lot better by looking at the betting odds.
. . . . "The central premise is that markets can reveal information about future events," said Forrest Nelson, an economics professor at the university and board member of the Iowa Electronic Markets.
So far, Nelson says the market has proven fairly accurate in predicting presidential elections. In the last four presidential contests, traders' predictions for candidate vote totals have come within 1.5 percent, on average, of the actual results. (Emphasis added)
http://www.wired.om/news/politics/0,1283,55730,00.html?tw=wn_story_related
Researcher Joyce Berg and her University of Iowa colleagues compared the accuracy of IEM predictions to polling predictions. They found that the markets consistently outperformed the polls because of their unique ability to attract and process good information.
Results From a Dozen Years of Election Futures Markets Research
Joyce Berg et. al., November, 2000
. . . Relative to polls, the markets rely on very different mechanisms for data collection and aggregation. Polls ask the question, "If the election were being held today, do you think you would vote for the Democratic candidate or for the Republican candidate?" They rely on a representative sample of likely voters, truthful responses to the poll questions and classical statistics to arrive at their prediction of election outcomes. In the Iowa Markets, traders receive an explicit financial reward tied to correctly answering the question, "Who will everyone vote for on election day?"
How and why do election futures markets "work?"
For the markets to work in theory, two features must be present. First there must be enough traders so that the aggregate of their knowledge can forecast correctly the outcome of the election. Second, the market mechanism must facilitate aggregation of their disparate information so that the prevailing market price becomes a sufficient statistic for their collective information.
. . . [T]he differences between election markets and polls give the markets an edge in prediction. Not only are the traders paid for correct guesses about the eventual election outcomes, but the market information set also includes previous market outcomes, poll results, and any other information deemed relevant by traders.
If the history of the Iowa Electronic Market is any indicator, the magic of the market includes a crystal ball to the political future. As the campaign draws to a close and the final frenzy of conflicting polls and predictions drives everyone to distraction, you can ignore it all. Now you know how to find the best information processor there is - the magic of the market.
Small Group Discussion Questions
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When the IEM Presidency futures market opened in June, participants could simply buy a REP04 or a DEM04 contract, depending on who they thought would win. For 3 months, the futures prices indicated a very close race, with neither candidate pulling far ahead.
In September, the contracts were split to reflect this close race.
The chart below is the 04 Presidential Winner-Take-All futures on the Iowa Electronic Market on Tuesday morning, Oct. 12th:Quotes current as of 11:15:03 CST, Tuesday, October 12, 2004.
Symbol Bid Ask Last Low High Average DEM04_G52
0.203 0.210 0.209 0.200 0.209 0.203 DEM04_L52
0.257 0.263 0.257 0.255 0.264 0.257 REP04_L52
0.254 0.261 0.255 0.240 0.270 0.261 REP04_G52 0.286 0.289 0.287 0.276 0.290 0.284 Purchasing a DEM04_G52 contract means that if the Democrats (John Kerry) get greater than 52% of the popular vote and win the presidency, the contract holder receives $1.
Purchasing a DEM04_L52 contract means that if the Democrats get less than 52% of the popular vote and win the presidency, the contract holder receives $1.
Similarly, a REP04_L52 contract pays if George Bush receives less than 52% of the popular vote and wins the presidency, and REP04_G52 pays if he receives greater than 52% and wins the presidency.(Read the prices as if there were a $ sign before the 0. So, 0.203 is $0.203 or 20.3¢.)
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How can a candidate receive less than 52% of the popular vote and win the presidency?
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What is the predicted outcome of the presidential race? (Use the "Last" column, which gives the prices as the end of the day before. Add together the prices of the 2 DEM contracts and of the 2 REP contracts.)
George Bush _____% John Kerry ______%
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Check the prices today. (http://128.255.244.60/quotes/78.html ) Has the predicted outcome of the election changed?
- If the predicted outcome has changed, what do you think has caused
it to change? (What new information has the market taken into account?)
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http://128.255.244.60/graphs/graph_Pres04_WTA_jpg.cfmThe graph above traces the history of the 04 Presidential market.
- What happened to people's expectations about the chances of a Bush victory in September?
- How do you know?
- What new information do you think changed people's expectations?
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http://www.biz.uiowa.edu/iem/archive/BFNR_2000.pdfThe graph above compares the accuracy of polling data and markets in predicting the outcome of the last 4 presidential elections. In all 4 elections, the market equaled or outperformed the polls (a result which held true in 49 markets for 41 elections in 13 countries included in the Berg study). Based on the information given in the reading, what hypotheses would you offer to explain the better performance of the markets in the 1988 and '92 elections compared to the '96 and 2000 elections?
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People frequently buy gold when they feel that the future is uncertain or risky, and sell gold (in order to buy stocks, for example) when they are optimistic about the future. On October 12th, 2004, the spot (current) price of gold on the American Precious Metals Exchange (http://apmex.com/home.asp) was $413.80/oz. The futures price, reported by CNN Money (http://money.cnn.com/markets/commodities.html) was $420.50 for delivery in December.
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What does the comparison of the spot price and December price tell us about buyers' expectations regarding the relative scarcity of gold from now until the end of the year?
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Predict what would happen to the futures price of gold if the U.S. were to capture Osama bin Laden, round up the major terrorists in the Middle East, conduct elections and withdraw from a peaceful Iraq before the end of the year.
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Using the links above, check the spot and futures prices of gold today. How do they compare to October 12th? If there are differences, what do they indicate about changes in people's expectations? Why do you think changes occurred (or did not occur)?
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Uncomfortable Question
In the summer of 2003, it came to the attention of the Congress that DARPA, the Defense Advanced Research Projects Agency, was exploring the possibility of using the Policy Analysis Market, a futures market known as PAM, as a tool for predicting terrorist strikes.
Bets Off on Terror Futures Index
Associated Press, July 29, 2003
. . . The little-publicized Pentagon plan envisioned a potential futures trading market in which speculators would wager on the Internet on the likelihood of a future terrorist attack or assassination attempt on a particular leader. . . .
When the plan was disclosed by two Democratic senators Monday, the Pentagon defended it as a way to gain intelligence about potential terrorists' plans.
. . . The program is called the Policy Analysis Market. DARPA said it was part of a research effort "to investigate the broadest possible set of new ways to prevent terrorist attacks."
Traders would have bought and sold futures contracts -- just like energy traders do now in betting on the future price of oil. But the contracts in this case would have been based on what might happen in the Middle East in terms of economics, civil and military affairs or specific events, such as terrorist attacks.
Holders of a futures contract that came true would have collected the proceeds of traders who put money into the market but predicted wrong.
Read the entire article at: http://www.wired.com/news/politics/0,1283,59813,00.html
The Case for Terrorism Futures
By Noah Shachtman, July 30, 2003
. . . [E]xchanges "tend to predict events really well when no one person knows the answer -- when information is distributed among many people with different knowledge bases," said Joyce Berg, a University of Iowa professor who helped organize the political trading floors. "Markets have been shown to be really good at aggregating that information."
Markets also bring together people with information about a particular subject in a way blue-ribbon panels of experts can't, added Hanson.
"You get people that know things about a subject, but don't have the credentials to say so," he said. "You get people who live in these areas (of the Middle East)."
There's also "less of an ability to spin" in markets than in policy debates, Hanson noted. "So you get what people actually think, not what they say."
. . . Members of the Senate are concerned, however, that by creating a financial market for Middle East events, a terrorist could basically bet on himself, and profit from his strikes.
Senate Minority Leader Tom Daschle (D-S.D.) expressed the feelings of several colleagues when he called PAM "an incentive actually to commit acts of terrorism."
But Daschle has it all wrong, according to Pennock, the market academic.
"The very fact of the terrorist doing that (investing money in an attack) would reveal his hand," he said. Prices would rise as the terrorist invested his cash, and that would tip leaders off to the potential for a strike.
"The market would know something is going to happen that people never would have known otherwise," Pennock added.
Read the entire article at: http://www.wired.com/news/politics/0,1283,59818-2,00.html?tw=wn_story_page_next1
The flap in the Senate was immediate and loud - from both sides of the aisle. Interestingly, however, little attention was given to whether or not PAM would work.
What do you think?Results From a Dozen Years of Election Futures Markets Research
"'This is just wrong,' declared Daschle, a South Dakota Democrat.
. . . Appropriations Committee chairman Sen. Ted Stevens (R-Alaska) . . . agreed 'that this should be immediately disestablished.'
. . . Sen. Hillary Rodham Clinton (D-New York), said she was appalled to hear of plans to set up 'a futures market in death.'
. . . 'The idea of a federal betting parlor on atrocities and terrorism is ridiculous and it's grotesque,' said Sen. Ron Wyden (D-Oregon) . . . . "
Is the benefit to society of an arguably effective predictor of terrorist attacks worth the cost of creating a market in which some people may profit from the dissemination of information about horrifying violence?
Teacher Guide
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Quotes current as of 11:15:03 CST, Tuesday, October 12, 2004.
Symbol Bid Ask Last Low High Average DEM04_G52
0.203 0.210 0.209 0.200 0.209 0.203 DEM04_L52
0.257 0.263 0.257 0.255 0.264 0.257 REP04_L52
0.254 0.261 0.255 0.240 0.270 0.261 REP04_G52 0.286 0.289 0.287 0.276 0.290 0.284 -
How can a candidate receive less than 52% of the popular vote and win the presidency? The distribution of the popular vote may be such that the candidate wins the electoral vote. (Students may also note that the candidate could win more than 50% but less than 52% of the popular vote.)
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What is the predicted outcome of the presidential race? (Use the "Last" column, which gives the prices as the end of the day before. Add together the prices of the 2 DEM contracts and of the 2 REP contracts.)
George Bush _54.2__% John Kerry _46.6___%
Note: Students may comment that the total is 100.8%, an obvious impossibility. Explain that this is simply a statistical variation (that derives from the bid/ask spread).
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Check the prices today. (http://128.255.244.60/quotes/78.html ) Has the predicted outcome of the election changed? Answers will vary. However, absent a major event that disrupts that last weeks of the campaign, expect that the difference in projected vote totals will remain small.
- If the predicted outcome has changed, what do you think has caused it to change? (What new information has the market taken into account?) Answers will vary.
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The graph above traces the history of the 04 Presidential market.
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What happened to people's expectations about the chances of a Bush victory in September? They increased.
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How do you know? Because buyers were willing to pay much more (up to 74¢) for a Bush contract.
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What new information do you think changed people's expectations? Answers will vary, but the major event of this time was the swift boat controversy, which caused a dip in Kerry's popularity.
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The graph above compares the accuracy of polling data and markets in predicting the outcome of the last 4 presidential elections. In all 4 elections, the market equaled or outperformed the polls (a result which held true in 49 markets for 41 elections in 13 countries included in the Berg study). Based on the information given in the reading, what hypotheses would you offer to explain the better performance of the markets in the 1988 and '92 elections compared to the '96 and 2000 elections?. . . Based on information from the reading students should identify the possibilities that fewer people participated in the later markets, and/or that the people participating brought less knowledge and experience to the market. (Perhaps the popularity of the market as a teaching or entertainment tool precipitated this effect.) Students may also mention that it may be harder to discriminate in closer elections. (Note that none of these should be stated as conclusions, but as hypotheses to investigate if one were trying to explain the difference in accuracy.)
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What does the comparison of the spot price and December price tell us about buyers' expectations regarding the relative scarcity of gold from now until the end of the year? They expect it to be slightly more scarce. (Note that an examination of past trends would be necessary to determine whether a $7/oz. increase is significant.)
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Predict what would happen to the futures price of gold if the U.S. were to capture Osama bin Laden, round up the major terrorists in the Middle East, conduct elections and withdraw from a peaceful Iraq before the end of the year. (The futures price would drop. As people became more optimistic about the future, they would sell gold to purchase other investments, causing the price to drop.)
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Using the links above, check the spot and futures prices of gold today. How do they compare to October 12th? If there are differences, what do they indicate about changes in people's expectations? Why do you think changes occurred (or did not occur)? Answers vary but should be tied to people's optimism or pessimism.
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Uncomfortable Question
Teacher Note: The Uncomfortable Question handout has been deliberately separated from the Small Group Discussion handout. The FTE recommends that teachers read the complete versions of the articles referenced in the "Uncomfortable Question" handout, and think carefully about whether the included readings and discussion question are appropriate to their student populations. While the uncomfortable question is intended to be an interesting theoretical discussion about the potential of markets, it may be too uncomfortable for some communities and some groups of students.
What do you think?
Is the benefit to society of an arguably effective predictor of terrorist attacks worth the cost of creating a market in which some people may profit from the dissemination of information about horrifying violence? Answers will vary. Encourage students to couch their answers in terms of costs and benefits. Acknowledging moral considerations in the costs column may help students to maintain a tone of civic discourse, regardless of the conclusions they ultimately reach.
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(Optional) Explore other futures markets:
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Trade Sports http://www.tradesports.com/ (Includes a presidential predictor as well as futures markets for major sporting events.)
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Hollywood Stock Exchange http://www.hsx.com/ (Good track record of choosing Oscar winners)
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Foresight Stock Exchange http://www.ideosphere.com/fx/docs/FXdocs.cgi#Welcome (Uses ersatz currency to speculate on wide variety of issues from cloning to the possibility that Catholic priests will be allowed to marry, and uses the price of oranges to accurately predict the weather.)
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Sources
American Precious Metals Exchange http://apmex.com/home.asp (October 12, 2004)
Associated Press. "Bets Off on Terror Futures Index." Wired News, July 29, 2003. http://www.wired.com/news/politics/0,1283,59813,00.html (October 12, 2004)
Chicago Board of Trade http://www.cbot.com/
Commodity Futures Options market http://www.usafutures.com/commodityprices.htm (October 12, 2004)
CNN Money (both metals and commodities) http://money.cnn.com/markets/commodities.html (October 12, 2004)
Foresight Stock Exchange http://www.ideosphere.com/fx/docs/FXdocs.cgi#Welcome (October 12, 2004)
Hollywood Stock Exchange http://www.hsx.com/ (October 12, 2004)
Iowa Electronic Markets http://www.bix.uiowa.edu/iem/ (October 12, 2004)
Joanna Glasner. "Election Time: What Are the Odds?" Wired News, October 16, 2002. http://www.wired.com/news/politics/0,1283,55730,00.html?tw=wn_story_related (October 12, 2004)
Joyce Berg et. al. "Results from a Dozen Years of Election Futures Markets Research," http://www.biz.uiowa.edu/iem/archive/BFNR_2000.pdf (October 12, 2004)
Noah Shachtman. "The Case for Terrorism Futures." Wired News, July 30, 2003. http://www.wired.com/news/politics/0,1283,59818-2,00.html?tw=wn_story_page_next1 (October 12, 2004)
Trade Sports http://www.tradesports.com/ (October 12, 2004)