Friday, October 3, 2008

7 Traders Is All You Need

Prediction markets are not like surveys. You don't need 1,000 people on a prediction market to get something sensible.

In fact you need about seven traders. Seven. That's one reason why businesses are picking up prediction markets - you can learn so much with so little, and at close to zero risk.

Where did this magic number seven come from?

In the 1950s, Nobel Laureate Vernon Smith began running experimental markets in his "lab", which in this case meant his first year economics students. He made half the students buyers, half sellers, and gave buyers secret values (a demand curve) and sellers secret costs (a supply curve). And then he told them to go to it.

Buyers would announce bids, and sellers announce asking prices (sound familiar, iPredict traders?) and trade would occur when overlapping bids could be matched.

Although traders operated with very incomplete information, the market generally converged to prices and volumes consistent with the theoretical intersection of supply and demand curves, also known as a competitive equilibrium.

Smith's experiments were designed to find out the conditions in which markets start failing, and some of these tests asked how many traders does a market need to work? The answer was seven. Of course, more is always better - but only because that increases the available pool of information, not because markets require hundreds of traders to properly work.

Prediction markets really are fundamentally different to surveys, both in the number of people required and in the protections from various sources of bias.

Click here to listen to Vernon Smith talk about his experiments and to read more.

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