The rise of prediction markets started in the middle of the last decade, brought about by a combination of politics, psychology and technology.
The only good alternative to a few flawed opinions, some researchers argued, was a vast number of flawed opinions. The biases often canceled one another out. The legitimate information rose to the surface. It was the wisdom of crowds, as the writer James Surowiecki called his 2004 book.
The Internet made collecting the wisdom of crowds vastly easier than before.
The early successes of prediction markets were notable. […] Intrade was a more reliable guide to the 2006 midterm election than cable networks. On election night, its odds showed that the Democrats had become the favorites to retake the Senate, while television commentators were still telling viewers it was unlikely.
But the crowd was not everywhere wise. For one thing, many of the betting pools on Intrade and Betfair attract relatively few traders, in part because using them legally is cumbersome. […] The thinness of these markets can cause them to adjust too slowly to new information.
And there is this: If the circle of people who possess information is small enough […] the crowds may not have much wisdom to impart. “There is a class of markets that I think are basically pointless,” says Justin Wolfers, an economist whose research on prediction markets, much of it with Eric Zitzewitz of Dartmouth, has made him mostly a fan of them. “There is no widely available public information.”
But such schadenfreude raises a question: once you accept that prediction markets are flawed, do you turn back to the inside experts?
ALAS, the experts’ overall record remains as poor as the behavioral economists maintained - and often worse than the markets’ record. … [C]onsider the housing bubble: both the market and most experts missed it.
The answer, I think, is to take the best of what both experts and markets have to offer, realizing that the combination of the two offers a better window onto the future than either alone. Markets are at their best when they can synthesize large amounts of disparate information, as on an election night. Experts are most useful when a system exists to identify the most truly knowledgeable - a system that often resembles a market.