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Friday, October 27, 2006

Microeconomics quiz of the week

From the Wall Street Journals' ProfessorJournal.com:
"If you want to sneak peak into who's up and who's down in this year's elections, don't seek out John Zogby or some or some other pollster,... go to a gambling Web site like tradesports.com... What will pop up on your screen are the latest odds on every Senate race. As of Oct. 18 at 4 p.m. Bob Casey was an 87% favorite to wrestle the Pennsylvania seat away from Rick Santorum." The column reports that the tradesports website is a nice lesson in how futures markets work (including an online tutorial about how the markets work). The reason why the online futures markets are so good at predicting elections outcomes is "the wisdom of crowds" - the idea that a large group of individuals, when participating in a futures market, can predict an outcome better than an expert. "Or as [economist] F.A. Hayak put it: The myriad data necessary for predicting or directing economic outcomes are 'not given to a single mind.'" The column reports on the outcome of an article in American Economic Review ("Orange Juice and Weather," Richard Roll, December 1984, v. 74 n. 5, pp. 861-880): futures market for orange juice is a better predictor of weather patterns in Florida than weathermen, because they have so much money at stake in coming up with the right answer. The column also reports on an economic analysis of the inability to traders to manipulate these futures markets so as to earn a profit.

QUESTIONS:
1.) Why are futures markets in which players bet on which candidate will win an election better than polls at predicting election outcomes?

2.) How do orange juice futures markets forecast weather?

3.) When buying or selling election outcome futures, what types of information do gamblers use? Do they use surveys? Do they use hunches?

4.) How does the market for these futures aggregate the information of market participants so that the market price of the futures is a good forecast of election outcomes?

5.) Explain the "wisdom of crowds."

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