Interpreting Prediction Market Prices as Probabilities

IZA Discussion Paper No. 2092

FRB of San Francisco Working Paper No. 2006-11

23 Pages Posted: 25 Apr 2006

See all articles by Justin Wolfers

Justin Wolfers

University of Michigan at Ann Arbor - Department of Economics; University of Michigan at Ann Arbor - Gerald R. Ford School of Public Policy; The University of Sydney - Discipline of Economics; Brookings Institution - Economic Studies Program; Peterson Institute for International Economics; National Bureau of Economic Research (NBER); IZA Institute of Labor Economics; Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute); Kiel Institute for the World Economy

Eric Zitzewitz

Dartmouth College; NBER

Multiple version iconThere are 3 versions of this paper

Date Written: April 2006

Abstract

While most empirical analysis of prediction markets treats prices of binary options as predictions of the probability of future events, Manski (2004) has recently argued that there is little existing theory supporting this practice. We provide relevant analytic foundations, describing sufficient conditions under which prediction markets prices correspond with mean beliefs. Beyond these specific sufficient conditions, we show that for a broad class of models prediction market prices are usually close to the mean beliefs of traders. The key parameters driving trading behavior in prediction markets are the degree of risk aversion and the distribution on beliefs, and we provide some novel data on the distribution of beliefs in a couple of interesting contexts. We find that prediction markets prices typically provide useful (albeit sometimes biased) estimates of average beliefs about the probability an event occurs.

Keywords: Manski, information market, event future, options, futures, binary option

JEL Classification: D4, D8, G13

Suggested Citation

Wolfers, Justin and Zitzewitz, Eric W., Interpreting Prediction Market Prices as Probabilities (April 2006). IZA Discussion Paper No. 2092, FRB of San Francisco Working Paper No. 2006-11, Available at SSRN: https://ssrn.com/abstract=898597 or http://dx.doi.org/10.2139/ssrn.898597

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