Risk Markets And Politics

Monday, July 25, 2005

Knowledge Is Not Power

Last week at Volokh and Crooked Timber, a din arose relating to recent failures in prediction markets. At Timber, one blogger cited this list:

  • SCOTUS nomination futures markets (note that the SCOTUS confirmation futures markets will certainly work finely)
  • 2012 Olympic city futures markets (the markets saw Paris as the winner)
  • papacy futures markets (the Pope would come from Europe, said the markets, but they failed to divine Ratzinger and Germany as country of origin)
  • Michael Jackson futures markets (like the commentariat, the markets had him behind bars)
  • Purcell resignation futures market (the market said he would not resign)
  • George Tenet resignation futures market (idem)

  • Another aired the opinion that it will be a long time before futures markets such as Tradesports are "anything other than a cutesie fad."

    All of this is very short-sighted. As I stressed in the Risk Markets And Prediction Markets post and suggested in Overcrowding, the predictive ability of these markets is secondary to their usefulness in hedging risks. If price does not represent probability (value) due to a supply/demand imbalance, longshot effect, etc, this simply represents an opportunity for speculators to profit. The usefulness of a market for its participants is more important and politically interesting than the somewhat academic ideal of market price strictly corresponding to value.

    Todd Zywicki at Volokh can perhaps say it better:

    Hayek is not interested in the centralization of knowledge for knowledge's sake. Rather, he is interested in the way in which certain institutions (such as prices, language, and traditions) centralize huge amounts of information, boil it down into tacit knowledge, and then redistribute it to decentralized decision-makers in the form of prices, rules, traditions, etc. The "purpose" is not to collect the information at the center in order to make it more "accurate" or "better"; the purpose is to send it back out to decentralized decision-makers in order to allow them to better coordinate their affairs with one another. (my italics)

    Said another way, risk markets (you could call them "prediction markets") do not primarily exist for knowing but rather for doing. (Pragmatists would argue that doing is the ultimately the determinate of knowing in any case.)

    Said yet another way, market prices should be interpreted as means and not as ends. In a political context, this point was a basic insight of Anthony Downs in An Economic Theory of Democracy, where he wrote, "Thus social products are usually the by-products, and private ambitions the ends, of human action." The social product (in this case, the market price and the knowledge it represents) is logically incidental to the private motives of market participants, although it may nonetheless be highly correlated.


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