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Prediction markets are designed to aggregate information and produce predictions about future events. They elicit a collective estimate of the expected value or probability of a random variable, combining knowledge and intuition dispersed across an entire population of traders, i.e. insighters.
The market prediction is not a median or average of individual future expectations. It is a complex interaction, reflecting the game-theoretic interplay of insighters, as they get new information and change their intuition, as individuals and as an interacting group. Through their actions, prediction markets aggregate information from all participating individuals as well as their intuitions, incorporate polls and other sources of information and weight all of this information through the price formation process.
The market price reflects a forecast that is a perfect Bayesian integration of all the information spread across all of the traders. This is the equilibrium scenario called rational expectations. It is the assumption underlying the strong form of the efficient markets hypothesis in finance, or what Adam Smith called the invisible hand - a base for all financial and commodity markets in the last two centuries. |
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