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RE: A New Type Of Prediction Market: RoosterRed’s Prediction is Payoff (PIP) Markets
There is a TVM (time value of money) flaw in this model. The markets can only be in perfect equilibrium when the TVM for the participants is one (one bitcoin at the time of participation is worth one bitcoin at payout). This matters little for short term predictions, but a lot for long term predictions. Regardless, I think the model is promising for research in both short and long term cases, but it does have a TVM flaw that would prevent perfect equilibrium in many cases.
I should specify what Perfect Equilibrium is in the market, why it is interesting, and when it can actually be reached. Lay readers are probably confused. And even advanced readers might mistakingly think Perfect Equilibrium is impossible.
Perfect Equilibrium in a PIP market would mean the following conditions are true:
1. 1 BTC at the time the predictions are made is worth 1 BTC at payout.
2. The market predictions add up to 1 or 100% (to some negligible degree).
If the strong form of the Efficient Market Hypothesis (EMH) is true, the percentile market predictions will be the product of all publicly available information about the likelihood of the event in question, which means the payouts will be the market's expected value of each possible outcome. Many economic models controversially assume or conclude the later is true in any competitive market. What PIP markets uniquely give is a very clean real world model to investigate this.
In fact, N-Option PIP markets could help research the plausibility of the EMH by seeing how markets adjust to an increase in outcomes. A four person election shouldn’t be harder for efficient markets to deal with than a runoff election and is still a relatively simple market. If PIP markets either scale easily or breakdown rapidly then how many view the EFH could change. The glaring drawback of the PIP model is Condition 1 above.
When is 1 BTC at prediction worth the same as 1 BTC at payout (Condition 1)? Under a continuous discount rate function, never, but continuous discount rate functions are preposterous for very short period of times. If people truly know that payouts will happen and happen in a fair way, then in very short period of times their discount rates will be effectively zero. But there is a another path to perfect equilibrium most readers will miss.
If people truly know that payouts will happen and happen in a fair way, Condition 1 is effectively reached in all circumstances where participants would have held, not traded or spent, the prediction funds (the funds going into the PIP contract). This is trivial, but can be a little hard to immediately see. It is based on Opportunity Cost. If the next best option a predictor has is to simply hold the funds the duration of the contract, then they don’t have a discount rate in any meaningful way. They might if you ask them, and they would if you modeled using a continuous discount rate function, but, in any meaningful way, they don’t have time preferences for the funds they put into the contract.
I think I will be rewriting this article. But I now realize that this equilibrium--let's call it Outcome Payout Equilibrium--is a lot more interesting on its own. It is just forcing the market to attempt to create Expected Value instead of assuming Expected Value should or will eventually hold. I am sure this isn't an original idea, but I don't know why it isn't talked about. I just saw it as a solution to create a prediction market with the correct payouts that bewilderingly was not being used. The trouble for this very simple market to find equilibrium (fund/find Expected Value) is disconcerting to me.
I deleted a post on informational asymmetry because it was not accurate. Buying stocks is not like buying a used car in an informational asymmetric environment. It is like buying a used car in this environment:
Where the sellers and buyers both could be using different parts of publicly available information with little to no overlap: information does not flow between outcome choices. All this follows from arbitrage. Severe and persistent Outcome Payout Disequilibrium breaks the EMH.