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Sunday, July 03, 2005

Betting On The Next Supreme Court Justice Nominee

There are more than enough bloggers making their case for one person or another to fill the O'Connor vacancy for the Supreme Court. Most of them are far smarter (and better informed) than me (in the case of Ann Althouse, better looking, too).

So, rather than add my $0.02 and stump for one or another, I'd rather give the Finance Professor's spin on things. Markets are wonderful tools for processing information. Tradesports.com has just opened up prediction markets for contracts based on who will be the next nominee for the Supreme Court.

Prediction markets don't work well in predicting outcomes when information is centralized (like the recent papal election, which took place under very closed conditions). However, the information associated with the nominating process is much more dispersed in this case than it was for the passing of the papal title -- in the SCOTUS nominating process, there are a lot of individuals that each possess some piece of the puzzle. Prediction markets serve as a useful tool for aggregating all this information. So, it'll be interesting seeing how accurate they turn out to be.

For those of you that aren't familiar with how a prediction market like Tradesports works, the contract for a given nominee pays $1 if he's nominated, and $0 otherwise. With some pretty simple math, it's easy to show that the price that an individual would be willing to pay for a contract like this is the individual's subjective probability that the event will occur.

Let's take the contract for Emilio Garza as an example. It currently sells for $0.28. If an individual believes that there's actually a 35% chance of Garza being nominated, this contract is undervalued. So, the individual would purchase the contract. As they make purchases, the price will increase. As long as the price remains below $0.35, that individual would consider it a good investment, and would keep buying. Buying would continue until the price exactly matches the subjective probability of the investor "at the margin".

Likewise, if an investor thought the contract was overvalued (i.e. that the probability implied by the price was too high), they'd sell it (i.e. take the other side of the bet). This would drive prices down and would continues until the price was "fair" to the marginal investor. In other words, purchases and sales take place until both sides are "balanced".

At present, Garza leads the field at $0.28, with Luttig at $0.16 and Gonzales at $0.18.

Stay tuned. Unlike the last time there was a vacancy, there will almost round the clock coverage of the process (both in mainstream media and the blogosphere). As information changes, prices on the contracts change to reflect traders assessments of each candidate's chances. So, these contracts serve as good bellwethers as to how the candidates perceived chances are changing.

Remember - unlike polls (formal or informal), these contracts require people to "put their money where their mouth is). That's their advantage as a predictive tool.

Update:

Welcome to all the folks stopping by from ProfessorBainbridge.com . Look around a bit and see if there's anything you like.

Also, since there seems to be a bit of interest on the topic, I'll be posting more about how to interpret the information you find on Tradesports (i.e. what are the "bid and ask prices, how do you interpret the order book, and so on).

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