I don’t know how to reply on your blog, so I write my thoughts on a couple of points here.
An event like “a hurricane appears before the end of the year” may harm an insurance company that offers flood insurance, without there being some firm that benefits by the same amount who wants to take the other side of the risk.
The bet on the event itself is already the insurance. Or viewed differently, the insurance itself is a bet in some kind of prediction market on the event. Which goes to show that it does not need two economic actors with opposite exposition to some event, as in your example of the baker and the farmer w.r.t wheat prices, but it is enough that two actors have different exposition to some event. Though of course in the case of non-opposite exposition there will have to be some kind of premium for one of the sides, meaning that the market price can not be interpreted simply as a probability of the event happening.
Edit: The more I think about it, the more I have to disagree with the basic point about liquidity. For a proper market there needs to be unbiased participant and the person being affected by the event. And there always is the second person or the outcome of the event is without any meaningful economic consequence. Weather affects groth of plants, avenues visited by customers and traffic for transport of goods. Sports outcomes affect a populations happiness and their choices of activity afterwards. Scientific results make specific products plausible or impossible. And so on.
If I am affected by a specific outcome of an event in a positive way, I can reduce my exposition by betting on the opposite outcome and increase my exposition by betting on the exact outcome. If there is a person being affected in opposite ways than I am, we can take the opposite sides of the bet. Else I need someone willing to merely take on some more risk than he is already exposed to, though the person will want to be compensated for that additional risk in some way. I wonder, is this distortion measurable so to recover the “underlying” probabilites?
I think your point is correct that if there is only economic exposure on one side of a market, then it affects the interpretability of the market prices, as it then becomes an insurance market which requires a premium for the other side of the trade. (With normal insurance, you pay the premium upfront and the insurance underwriter invests that money for earnings, so insurance prices are actually much closer to the actuarially correct price than one would naively expect.) Depending on the size of the market, though, the premium could be small.
I agree that a market COULD be formed without symmetric event risk, I just think it’s unlikely that we will see one formed. I think the symmetry makes a market much more likely, and economics is first a social science, so proving that something is possible is far from proving that it will occur. A market has costs to operate, so it has to have a compelling reason to exist, and bringing together natural participants is one of these core reasons. Another factor that would make a public market more likely is a larger number of smaller participants (there were a large number of small farmers when the commodity markets were established, for example).
Probability of a public prediction market forming is increasing with: number of participants exposed to an identical event, balanced natural exposure to the event from each side, and accuracy of the forecasts for the impact on economic outcomes of that event (if your price goes up, your profit goes up in an easily forecastable way). Most futures markets have all three of these, but since events that are hard to forecast (and thus need prediction markets) also have impacts that are hard to forecast, prediction markets so far seem to have hard time scoring high in that third category. Most binary events that have economic impacts are also either broadly good or bad, which makes the second category difficult. Part of this may be lack of imagination on my part, of course, and as I said previously, I would like to be proved wrong.
Most binary events that have economic impacts are also either broadly good or bad, which makes the second category difficult. Part of this may be lack of imagination on my part, of course, and as I said previously, I would like to be proved wrong.
Define binary, because my imagination does not come up with many examples that are not more like some linear events, e.g. amount of rain as opposed to “it rains”.
Also, in almost all of the cases I come up with, there is a benefactor. With rain people stay indoors and use more electricity, consume more television and hang out more on the internet. With a negative scientific result a product becomes unviable which ensures the market position of another market participant. And so on. Keep in mind that for a prediction market to work in an unbiased manner, there only needs to be a benefactor relative to someone that loses, that is total wealth can decrease, but not uniformly.
Lastly, the rise of the second and third world will ensure that there are more than enough market participants for most questions, at least I think so. I have no model to predict this, but base this on a gut feeling. Maybe we can construct some examples to get a feeling on what point we disagree on?
I don’t know how to reply on your blog, so I write my thoughts on a couple of points here.
The bet on the event itself is already the insurance. Or viewed differently, the insurance itself is a bet in some kind of prediction market on the event. Which goes to show that it does not need two economic actors with opposite exposition to some event, as in your example of the baker and the farmer w.r.t wheat prices, but it is enough that two actors have different exposition to some event. Though of course in the case of non-opposite exposition there will have to be some kind of premium for one of the sides, meaning that the market price can not be interpreted simply as a probability of the event happening.
Edit: The more I think about it, the more I have to disagree with the basic point about liquidity. For a proper market there needs to be unbiased participant and the person being affected by the event. And there always is the second person or the outcome of the event is without any meaningful economic consequence. Weather affects groth of plants, avenues visited by customers and traffic for transport of goods. Sports outcomes affect a populations happiness and their choices of activity afterwards. Scientific results make specific products plausible or impossible. And so on.
If I am affected by a specific outcome of an event in a positive way, I can reduce my exposition by betting on the opposite outcome and increase my exposition by betting on the exact outcome. If there is a person being affected in opposite ways than I am, we can take the opposite sides of the bet. Else I need someone willing to merely take on some more risk than he is already exposed to, though the person will want to be compensated for that additional risk in some way. I wonder, is this distortion measurable so to recover the “underlying” probabilites?
I think your point is correct that if there is only economic exposure on one side of a market, then it affects the interpretability of the market prices, as it then becomes an insurance market which requires a premium for the other side of the trade. (With normal insurance, you pay the premium upfront and the insurance underwriter invests that money for earnings, so insurance prices are actually much closer to the actuarially correct price than one would naively expect.) Depending on the size of the market, though, the premium could be small.
I agree that a market COULD be formed without symmetric event risk, I just think it’s unlikely that we will see one formed. I think the symmetry makes a market much more likely, and economics is first a social science, so proving that something is possible is far from proving that it will occur. A market has costs to operate, so it has to have a compelling reason to exist, and bringing together natural participants is one of these core reasons. Another factor that would make a public market more likely is a larger number of smaller participants (there were a large number of small farmers when the commodity markets were established, for example).
Probability of a public prediction market forming is increasing with: number of participants exposed to an identical event, balanced natural exposure to the event from each side, and accuracy of the forecasts for the impact on economic outcomes of that event (if your price goes up, your profit goes up in an easily forecastable way). Most futures markets have all three of these, but since events that are hard to forecast (and thus need prediction markets) also have impacts that are hard to forecast, prediction markets so far seem to have hard time scoring high in that third category. Most binary events that have economic impacts are also either broadly good or bad, which makes the second category difficult. Part of this may be lack of imagination on my part, of course, and as I said previously, I would like to be proved wrong.
Define binary, because my imagination does not come up with many examples that are not more like some linear events, e.g. amount of rain as opposed to “it rains”.
Also, in almost all of the cases I come up with, there is a benefactor. With rain people stay indoors and use more electricity, consume more television and hang out more on the internet. With a negative scientific result a product becomes unviable which ensures the market position of another market participant. And so on. Keep in mind that for a prediction market to work in an unbiased manner, there only needs to be a benefactor relative to someone that loses, that is total wealth can decrease, but not uniformly.
Lastly, the rise of the second and third world will ensure that there are more than enough market participants for most questions, at least I think so. I have no model to predict this, but base this on a gut feeling. Maybe we can construct some examples to get a feeling on what point we disagree on?