Key Concepts

• In 1988 the University of Iowa launched an experiment to test whether a market using securities for presidential candidates could predict the outcome of the election.
• In presidential elections from 1988 to 2004, the Iowa Electronic Markets have predicted final results better than the polls three times out of four.
• Despite the track record of the Iowa market, a fund­amental understanding of how prediction markets work remains elusive, and economists are still trying to develop a body of theory to provide definitive answers.

The Editors

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.

Make Your Best Bet
When the three academics—George R. Neumann, Robert Forsythe and Forrest Nelson—sought support from the university, the dean of its business college, a free-market advocate, could not contain his enthusiasm. On the other hand, the dean of the college of arts and sciences, a political scientist, characterized the proposal as “the stupidest thing he had ever heard of,” Neumann recalls. “At best, it would be a shadow of the polls,” he was told.

With the business school dean onboard, the three pressed forward. They wanted to use real money as an incentive for participants to take the exercise seriously. But they needed permission to allow students and faculty to gamble legally on campus. The university’s general counsel resisted, but Iowa’s state attorney general let the real-money market go ahead under a state law that permits office-betting pools.

The World Wide Web was still a glint in the eye of Tim Berners-Lee when the Iowa Political Stock Market opened on June 1, 1988. Nearly 200 students and faculty members began buying contracts on George H. W. Bush, Dukakis and others using the relatively primitive tools of the pre-Web Internet. A Bush or Dukakis contract was bought or sold in a futures market, the same type in which Iowa hog farmers trade pork bellies. Instead of pigs, however, the investors in the Iowa Political Stock Market were trading contracts on the share of the vote that a candidate would receive on Election Day.

Up until the morning of the election, traders carried out their transactions, although a rule stipulated that no one could invest more than $500. Taking a simplified example, a Bush contract in the vote-share market paid $0.53, corresponding to Bush’s 53 percent of the vote, and a Dukakis contract paid $0.45, tied to the Democrat’s popular vote percentage. If you had bought a Bush security at $0.50 before the market closed the morning of the election, you would have made a gain of $0.03.