Risk Aversion , Beliefs , and Prediction Market Equilibrium

Manski [2004] analyzes the relationship between the distribution of traders’ beliefs and the equilibrium price in a prediction market with risk neutral traders. He finds that there can be a substantial difference between the mean belief that an event will occur, and the price of an asset that pays one dollar if the event occurs and otherwise pays nothing. This result is puzzling, since these markets frequently produce excellent predictions. This paper resolves the apparent puzzle by demonstrating that both risk aversion and the distribution of traders’ beliefs significantly affect the equilibrium price. For coefficients of relative risk aversion near those estimated in empirical studies and for plausible belief distributions, the equilibrium price is very near the traders’ mean belief. The paper also describes a proposed test of the relationship between the predicted market equilibrium and the distribution of traders beliefs. this test includes a prediction market that is run concurrently with a belief elicitation procedure and an elicitation procedure for risk attitudes. JEL Classification: D84, G10