[Link] Small-game fallacies: a Problem for Prediction Markets

Nick Szabo writes about the dangers of taking assumptions that are valid in small, self-contained games and applying them to larger, real-world “games,” a practice he calls a small-game fallacy.

Interactions between small games and large games infect most works of game theory, and much of microeconomics, often rendering such analyses useless or worse than useless as a guide for how the “players” will behave in real circumstances. These fallacies tend to be particularly egregious when “economic imperialists” try to apply the techniques of economics to domains beyond the traditional efficient-markets domain of economics, attempting to bring economic theory to bear to describe law, politics, security protocols, or a wide variety of other institutions that behave very differently from efficient markets. However as we shall see, small-game fallacies can sometimes arise even in the analysis of some very market-like institutions, such as “prediction markets.”

This last point, which he expands on later in the post, will be of particular interest to some readers of LW. The idea is that while a prediction market does incentivize feeding accurate information into the system, the existence of the market also gives rise to parallel external incentives. As Szabo glibly puts it,

A sufficiently large market predicting an individual’s death is also, necessarily, an assassination market...

Futarchy, it seems, will have some kinks to work out.