The research that led to future-predicting markets stems from the 1960s and 1970s, when Vernon Smith and Charles Plott, now of George Mason University and the California Institute of Technology in Pasadena, respectively, began using laboratory experiments to study different market designs. In the early 1980s, Plott and Shyam Sunder, now of Yale University, tested how well markets aggregate information by designing a set of virtual markets in which they carefully controlled what information each trader had.
In one experiment, Plott and Sunder permitted about a dozen study participants to trade a security, telling them only that it was worth one of three possible amounts–say, $1, $3, or $8–depending on which number was picked by chance. Plott and Sunder then gave two of the participants inside information by telling them which amount had been selected. Traders couldn’t communicate with each other; they could only buy and sell on the market.
“The question was, Would the market as a whole learn what the informed people knew?” Plott says. “It turned out that it would happen lightning fast and very accurately. Everyone would watch the movements of the market price, and within seconds, everyone was acting as if they were insiders.”
In another experiment, Plott and Sunder gave the inside traders less-complete information. For instance, if the outcome of the random pick were $3, they would tell some traders that it was not $1, and others that it was not $8. In these cases, the market sometimes failed to figure out the true value of the security.
However, if Plott and Sunder created separate securities for each of the three possible outcomes of the random pick instead of using one security worth three possible amounts, the market in which some traders had incomplete tips succeeded in aggregating the information.
The studies established that, at least in these simple cases, markets indeed can pull together strands of information and that different setups affect how well they do so.
This type of experiment gave researchers a “wind tunnel” in which to test different market designs, says John Ledyard, a Cal-tech economist who chairs the board of Net Exchange. “With experiments, we’re starting to zero in on what really works,” he says.
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