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News & Events

Economist bets on bright future of information markets

By Deborah Leigh Wood

4/1/2005 - Although puzzling, this futures vehicle can be more accurate than its conventional competitors, says John O. Ledyard, Nancy L. Schwartz Memorial Lecture speaker

Racetrack betting, office Super Bowl pools and online sites where people wager on the next pope or “American Idol” have researchers and the rest of the world scratching their heads over why these nontraditional speculative markets, called information markets, often predict outcomes better than polls, politicians and pundits.

“They’re indeed a puzzle, but when information markets work, the sky’s the limit,” said John O. Ledyard, the speaker at the 12th annual Nancy L. Schwartz Memorial Lecture, held April 13 at the Kellogg School’s Donald P. Jacobs Center. “The science just needs to be worked out to make them perform on a consistent basis.”

Used correctly, information markets can be a cheaper, faster and more accurate way than traditional asset markets to gain information, said Ledyard, the Alan and Lenabelle Davis Professor of Economics and Social Sciences at the California Institute of Technology, and a professor of economics from 1970 to 1985 at Northwestern University.

Information markets aggregate people's beliefs to help predict the likelihood of future events. They have "huge practical implications and applications," Ledyard explained in his lecture and a subsequent interview. He said these markets can be used by software companies to decide whether to keep a feature, by drug companies to predict whether a new medication will be successful and by car manufacturers to discover if their latest SUV will hit the market running or wind up in a financial ditch.

Information markets are most familiar to the public in the form of the Iowa Electronics Market, which accurately predicted that Bill Clinton would beat George H.W. Bush in the 1992 presidential elections. These markets also made the news in 2003 when the United States' Defense Advanced Research Projects Agency was preparing to trade futures contracts based on possible political developments in the Middle East. Politicians quickly nixed the idea, Ledyard said, when they mistakenly believed that they were to be used to predict terrorist attacks.

Information markets are beginning to be used internally in pilot programs by some Dow 30 companies. Several vendors have begun offering information market products and services to major private firms. Ledyard said one of these, Common Knowledge Markets, is a direct descendant of the Department of Defense. Consumers who want a piece of the action can go to sites such as HedgeStreet®, which bills itself as the only U.S. government-designated online market “where traders can hedge or speculate on economic outcomes.”

Most companies that use information markets do so internally to avoid the complex, expensive regulation process, Ledyard said. “They simply set up a local information market to evaluate a product or service and stake experts to buy and sell securities that focus on evaluation.”

Ledyard said if the company has designed a good set of securities and a good trading process, chances are that the experts’ opinions can be successfully aggregated. In a well-designed information market, he explained, companies ask questions such as, “How well will this product sell?” and not, “Will people be happy with it?”

Information markets tend to fall apart when some of the traders know more than the others, Ledyard noted. “Bias creeps in, and unless it is correctly designed, the person who has the most information about the situation acts like a monopolist and tries to manipulate the prices.”

Until researchers discover how information markets work, Ledyard said, people will keep drawing an analogy to the experiments of the Wright Brothers, who “kind of knew an airplane would work, but not exactly how.”

In the meantime, Ledyard said he is having fun with information markets because of their mystery and their potential to answer a lot of questions. And as for their future — he would most certainly bet on it.

Established in 1983, the annual lecture series, which focuses on issues of current economic theory, honors Schwartz, who was the Morrison Professor of Decision Sciences and the first woman faculty member appointed to an endowed chair at the Kellogg School. She collaborated with Ledyard while he was a professor of economics at Northwestern University.