In late March 1988 three economists from the University of Iowa were nursing beers at a local hangout in Iowa City, when conversation turned to the news of the day. Jesse Jackson had captured 55 percent of the votes in the Michigan Democratic caucuses, an outcome that the polls had failed to intimate. The ensuing grumbling about the unreliability of polls sparked the germ of an idea. At the time, experimental economics—in which economic theory is tested by observing the behavior of groups, usually in a classroom setting—had just come into vogue, which prompted the three drinking partners to deliberate about whether a market might do better than the polls.
A market in political candidates would serve as a novel way to test an economic theory asserting that all information about a security is reflected in its price. For a stock or other financial security, the price summarizes, among other things, what traders know about the factors influencing whether a company will achieve its profit goals in the coming quarter or whether sales may plummet. Instead of recruiting students to imitate “buyers” or “sellers” of goods and services, as in other economics experiments, participants in this election market would trade contracts that would provide payoffs depending on what percentage of the vote George H. W. Bush, Michael Dukakis or other candidates received.
If the efficient-market hypothesis, as the theory relating to securities is known, applied to contracts on political candidates as well as shares of General Electric, it might serve as a tool for discerning who was leading or trailing during a political campaign. Maybe an election market could have foretold Jackson’s win. Those beer-fueled musings appear to have produced one of the most notable successes in experimental economics—and have blossomed into a subdiscipline devoted to studying prediction markets that allow investing or betting (pick the term you like best) not just on elections but on the future of climate change, movie box-office receipts and the next U.S. military incursion.
