There is a very interesting piece in the New York Times today by David Leonhardt on the apparent backlash against prediction markets such as Intrade and Betfair. In principle, these markets make predictions by aggregating the disparate information of many independent bettors who offer prices for a particular outcome. Prediction markets have enjoyed a fair amount of success in recent elections. The University of Iowa has even set up an influenza prediction market. But prediction markets are hardly perfect and have had some pretty big recent failures. It turns out that Intrade failed in a pretty spectacular manner to predict the outcome of the recent Supreme Court ruling about the constitutionality of the Affordable Care Act. Leonhardt suggests that some of the failures of online prediction markets is attributable to relatively small number of people who actually trade on the market:
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. (No, I do not know from experience.) The thinness of these markets can cause them to adjust too slowly to new information.
This may have been an issue with the ACA decision but the primary problem with the incorrect prediction is that the crowd doesn't actually know much about the workings of the very closed social network that is the United States Supreme Court. Writes Leonhardt:
And there is this: If the circle of people who possess information is small enough -- as with the selection of a vice president or pope or, arguably, a decision by the Supreme Court -- 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.'
This point gets at a larger critique of market-based solutions to problems suggested by my Stanford colleague Mark Granovetter over 25 years ago (Granovetter 1985). This is the problem of embeddedness. The idea of embeddedness was anticipated by the work of substantivist economist Karl Polanyi, but Granovetter really laid out the details. Granovetter writes (1985: 487): "A fruitful analysis of human action requires us to avoid the atomization implicit in the theoretical extremes of under- and oversocialized conceptions [of human action]. Actors do not behave or decide as atoms outside a social context, nor do they adhere slavishly to a script written for them by the particular intersection of social categories that they happen to occupy. Their attempts at purposive action are instead embedded in concrete, ongoing systems of social relations." Atomization is independent bettors making decisions about the price they are willing to pay for a certain outcome.
The argument for embeddedness emerges in Granovetter's paper from the problem of trust in markets. Where does trust come from in competitive markets? The fundamental problem here regards the micro-foudnations of markets where "the alleged discipline of competitive markets cannot be called on to mitigate deceit, so the classical problem of how it can be that daily economic life is not riddled with mistrust and malfeasance has resurfaced." (p. 488). The obvious solution to this is that actors choose to deal with alters whom they trust and that the most effect way to develop trust is to have prior dealings with an alter.
Granovetter's embeddedness theory is a modest one. He notes that, unlike the alternative models, his "makes no sweeping (and thus unlikely) predictions of universal order or disorder but rather assumes that the details of social structure will determine which is found." (p. 493)
These ideas about the careful analysis of social structure and networks of interlocking relationships are fundamental for understanding when the crowd will be wise and when it will not. They are also essential for developing effective development interventions and, for that matter, making markets work for the public good in general. The theory of embeddedness allows for the possibility that markets can work but if we are to understand when they work and when they don't, we need to think about social structure as more than just a bit of friction in an ideal market and take its measurement more seriously. People are not ideal gases. (Dirty little secret: most gases are not ideal gases). This gets at some problems that I have been thinking about a lot recently relating to the implications of additive, observational noise vs. process noise and its implications for prediction of multi-species epidemics, but that must wait for another post...