In July, 2003, the Defense Advanced Research Projects Agency (DARPA), a research think tank within the U.S. Department of Defense, came up with a proposal for an unusual project. The project was to launch a Policy Analysis Market (PAM) where traders could wager on the likely occurrence of various economic and geopolitical events in the Middle East, including terrorist acts.

The program's goal was to harness the predictive powers of markets in order to get a better analytical handle on a maddeningly complex region of the world; and perhaps prevent another Sept. 11. However, a political uproar followed. Critics attacked DARPA for proposing "terrorism markets". The project was canceled a day after it was announced. Its head, Admiral (ret) John Poindexter, also resigned.

The idea behind PAM is not as dumb as it looks on first glance. It was soundly based on economic theory -- specifically, the theory of efficient markets and market discovery. In fact, on-line prediction markets like PAM have been available to the general public since the mid-1990s, allowing people to make bets on the likely outcomes of sports, entertainment, finance and political events. Some markets use real money, others use play money (including the Asian Foresight Exchange, AsianFX.net).

To get a sense of how such markets operate, consider a "winner-takes-all" election market. Suppose two candidates, A and B, are facing off. Anyone can enter the market by putting some money into the pool; for each dollar an investor puts in, he or she receives two contracts, one of which will pay US$1 if candidate A wins and one of which will pay $1 if candidate B wins.

Once contracts are in circulation, participants can buy and sell them to each other at a trading website. If the going rate for a candidate A contract is 53 cents, for instance, then the market as a whole thinks candidate A has a 53 percent chance of winning. Once the election results come out, participants cash in their winning contracts from the pool -- the more contracts of the winner they have, the more money they make.

What makes predictive markets interesting is that in many cases their track record in forecasting events has been exceptional, whether they operate with real money or play money. Consider, for example, the Iowa Electronics Market (IEM), which routinely outperforms opinion polls in predicting the ultimate results of political elections in the U.S. and abroad. The Hollywood Stock Exchange (HSX) -- which predicts box office results -- consistently outperforms industry forecasts. And then there is the eerily accurate Foresight Exchange (FX), where the trade prices closely correlate with actual outcome frequencies on a wide variety of goods, in some cases outperforming expert prognostications.

Why do many prediction markets work so well? For some reason they are extremely efficient at aggregating.

First, almost anyone can participate. In addition, as mentioned by James Surowiecki in his book Wisdom of Crowds, the absence of hierarchy -- markets do not have vice presidents -- ensures that no single person has too much influence and that diverse viewpoints do not get shut down.

Second, the incentive to get the better of others (whether the reward is profit or mere satisfaction) causes traders to seek out good information.

Third, markets reward the people who are right, not those who lie convincingly or are loudest or most aggressive or who have the longest string of titles after their name.

The corporate world is beginning to catch on to this. Some companies are experimenting with prediction markets in making business decisions. Siemens AG used an internal market to predict whether a software project would be completed on time. Hewlett- Packard used an internal market to forecast printer sales. Eli Lilly used one to estimate its chances of winning Food and Drug Administration approval for new products in the research pipeline. Goldman Sachs and Deutsche Bank host auctions for economic statistics futures, including employment, industrial output, retail sales and inflation. And, since a few months ago, Yahoo! has run Tech Buzz, prediction markets for high-tech products, to help predict future trends.

Despite the PAM debacle, Robin Hanson -- an economist at George Mason University and a leading advocate of prediction (idea) -- claims that such markets can be used to assess potential consequences of policy decisions by a government or other institutions. Indeed, Hanson wants to go further. In his paper Shall We Vote on Values, But Bet on Beliefs, Hanson proposed a new form of government, which he calls a "Futarchy". In this government, elected representatives would formally define and manage after-the-fact measurements of national welfare, while market speculators would say which policies they expected to raise national welfare.

Or consider Robert Hahn, director of the American Enterprise Institute-Brookings Joint Center for Regulatory Studies, who offers a simpler and less controversial idea. He believes that prediction markets could be of great help in forming policy, especially when combined with performance-related contracts.

In action, the Iowa Electronics Market is now running the Influenza Prediction Market, where the players are doctors, nurses and pharmacists across Iowa. The goal is to help Iowa hospitals and clinics prepare for a rush of flu cases.

Will such markets be considered by Indonesian business decision makers and policy makers? I do not know. What I do know is that these markets offer another way of getting people together to make smarter and better decisions.

The writer is a lecturer at Universitas Pelita Harapan and can be reached at enda@uph.edu.