Prediction Markets

Wisdom is not an innate property of crowds. French anthropologist Gustave Le Bon first described in 1895 the “magnetic influence emanating from a crowd" that unifies every individual’s opinion and behaviour until it starts acting as if it had a single group mind (Le Bon, 1895). For Le Bon, a crowd’s mind was inferior to an individual’s, “lacking the judgement of the critical spirit”. He connected the crowd mind to the rise of far-right sentiment and racism in 19th century Paris. Austrian psychologist Sigmund Freud also found the crowd mind to be "impulsive, changeable, and irritable” (Freud, 1921).

Later findings turned this initially unfavourable impression on its head. Empirical researchers started to realise that the quality of the crowd mind depends on the institutions and mechanisms regulating their individual members’ interaction. English philosopher Francis Galton described in “Vox Populi” a now famous first example of crowd intelligence. Farmers attending a country fair had to guess the weight of an ox to win a prize. The 787 participants’ individual forecast errors varied considerably, but the crowd’s median forecast was almost perfect, suggesting an intelligent and foresightful group mind (Galton, 1906). However, Galton did not yet recognise the importance of the (betting) transaction format in eliciting reliable knowledge.

It was Austrian economist and Nobel laureate F.A. Hayek who proposed in 1945 that the prices produced by a crowd interacting through a market mechanism represent condensed information, or intelligence (Hayek, 1945). He famously stated that: “We must look at the price system as a mechanism for communicating information if we want to understand its real function”.

Half a century later another Nobel laureate, American economist Vernon Smith, tested this hypothesis with a clever laboratory experiment. He set up a virtual stock market and showed that market prices indeed converge to express the collective knowledge of market participants, even if information is only held privately by some individuals in a crowd (Smith, 1982).

American science journalist James Surowiecki finally popularised the favourable conclusion about crowd intelligence by summarising a body of evidence for the superior foresight of the group mind in his 2004 book “The Wisdom of Crowds”.

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