The prices of buy and sell contracts for the Republican presidential candidates in Iowa provide a good history of the beginning of the primary race.
Romney contracts (max of $1) on the first and last day of each month since September 1 were:
This is how the market works:
The Iowa Electronic Market (IEM) indicates the probability that a candidate will finish in the top 2 in the Iowa caucuses. So, a 22-cent contract displays a 22% probability. Like any market, the price representing a Romney victory fluctuates because of supply and demand.
Explained on the IEM website, “Contracts for the correct outcome pay off at $1; all other contracts pay off at zero. As a result, the price of the contract at any given time is the probability that the traders believe that event will happen.” The maximum investment is $500.
Polls or Markets? This study says the markets were more accurate than polls 3/4 of the time between 1988 and 2004.
The Economic Lesson
Former Secretary of the Treasury Lawrence Summers said that the most important idea to learn about the U.S. economy is “the power of the market.” As a process that creates prices and quantities for goods and services, markets are a source of information and incentives for businesses and consumers.
Through their price making mechanism, prediction markets might also be a forecasting tool.
An Economic Question: Here, the Iowa futures are shown for the 2012 presidential election. What do the numbers display?