TLDR: Prediction markets rely on efficiency, but efficiency is not guaranteed.
Prediction market structures can work. However, they rely on so many different components being in place that they do not consistently create accurate probability.
The systems rely on complete market efficiency, which is not realistic.
In my first post on prediction markets, I broadly covered how prediction markets can act as a source of truth in a dark cloud. I also listed three fallacies that prevent specific markets from reaching true probability. This second article attempts to go in-depth on those three fallacies: skew from bias, hedging, and time.
Market efficiency
Market efficiency is integral to the accuracy of prediction markets because, without efficiency, probability skews exist.
This is an example of market efficiency in the purest form:
- A market is set up on a coin flip, with the market maker selling flips at 55c. The market-maker effectively receives a 10% edge for each flip because he is selling .5 odds at .55. In this example, the buyer expects to lose 5c per coin flip.
- Another market maker sees the market and