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Interpreting Prediction Market Prices as Probabilities

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  • Justin Wolfers
  • Eric Zitzewitz

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 of 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.

Suggested Citation

  • Justin Wolfers & Eric Zitzewitz, 2006. "Interpreting Prediction Market Prices as Probabilities," NBER Working Papers 12200, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:12200
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    References listed on IDEAS

    as
    1. Manski, Charles F., 2006. "Interpreting the predictions of prediction markets," Economics Letters, Elsevier, vol. 91(3), pages 425-429, June.
    2. repec:reg:rpubli:259 is not listed on IDEAS
    3. Justin Wolfers & Eric Zitzewitz, 2004. "Prediction Markets," Journal of Economic Perspectives, American Economic Association, vol. 18(2), pages 107-126, Spring.
    4. Leigh, Andrew & Wolfers, Justin & Zitzewitz, Eric, 2003. "What do Financial Markets Think of War in Iraq?," Research Papers 1785, Stanford University, Graduate School of Business.
    5. Ali, Mukhtar M, 1977. "Probability and Utility Estimates for Racetrack Bettors," Journal of Political Economy, University of Chicago Press, vol. 85(4), pages 803-815, August.
    6. Steven Gjerstad, 2004. "Risk Aversion, Beliefs, and Prediction Market Equilibrium," Microeconomics 0411002, EconWPA.
    7. Jeff Dominitz & Charles F. Manski, 2004. "How Should We Measure Consumer Confidence?," Journal of Economic Perspectives, American Economic Association, vol. 18(2), pages 51-66, Spring.
    8. Steven D. Levitt, 2004. "Why are gambling markets organised so differently from financial markets?," Economic Journal, Royal Economic Society, vol. 114(495), pages 223-246, April.
    Full references (including those not matched with items on IDEAS)

    More about this item

    JEL classification:

    • D4 - Microeconomics - - Market Structure, Pricing, and Design
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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