Manipulation and (Mis)Trust in Prediction Markets

Abstract

When it is common knowledge that there are no manipulators, the prediction market correctly identifies the true state of the world. If participants are told that manipulators may be present, the volatility of prediction market prices increases. If the suspicion is unfounded, the market can still identify the true state. Unfortunately if manipulators are present, it is harder for the market to identify the correct answer. When there are manipulators, managers under-utilize the information revealed in prices. Furthermore, mere suspicion of manipulation erodes trust in the market, leading to the implementation of suboptimal policies — even if actual manipulation is absent.