A New 'Wind Tunnel' For Companies

Companies are always trying to predict the future. These days, the field of experimental economics--which replicates market and business scenarios in the lab--is giving the crystal ball an upgrade. Hewlett-Packard scientists, for example, have created mini-markets that allow its executives to bet on, among other things, future sales and revenue. The internal futures markets do a better job of predicting than simply polling the executives because anonymous bids bypass office politics, and cash rewards (up to $250 for the best bets) provide extra incentive. Another of its fortune-telling exercises uses Stanford students acting as HP execs, retailers and suppliers in a kind of Simbusiness test of new strategies.

Remember the Defense Department's ill-fated proposal to create a terror futures market this year? The tone-deaf idea was quickly shot down, but the underlying science is being explored by a handful of large companies like IBM, Microsoft and Ford. Experimental economics is "a wind tunnel for business," says HP senior scientist Kay-Yut Chen.

Testing economic theories through experiments sounds like a no-brainer, but it wasn't always so. Vernon Smith, a professor at George Mason University, began doing it in 1956. Over the years, he and others like Caltech professor Charles Plott crafted experiments that proved markets' predictive power. Their work has influenced policy decisions on issues like airport-landing rights. Last year Smith was awarded the Nobel Prize.

Now big business wants to know more about the research that the Swedes say "changed the direction of economic science." Earlier this month Microsoft invited Net Exchange, the company that developed terror futures, to brief researchers on predictive markets. Despite the Pentagon fiasco, terror futures may be reborn in the private sector: Net Exchange is fielding offers from investors who want to sell results from a geopolitical risk market to insurance and financial-service firms. Net Exchange and others are also looking to build predictive markets for Big Pharma. Incentive Markets in Boston claims to have set up an internal futures market for a top-10 drug company that allows employees to bet on the success of products in the pipeline.

Plott, the Caltech professor, recently created a new bidding system for auto auctioneer Manheim. Trial results showed a 9 percent increase in the price of each car. Kay-Yut Chen of HP runs tests that have resulted in new incentives for retailers and more effective penalties for price cutters (HP now trims retailers' marketing funds). HP recently showed Ford that even in tough times, customers are more willing than the automaker thought to buy cars they had leased (buyers want to stick with a known quantity). Ford has signed up for an even bigger project. The crystal ball suggests HP may be on to something.