Incentive compatibility in prediction markets: Costly actions and external incentives

Abstract

We consider a multi-round prediction market in which two agents, Alice and Bob, are trading on an event on which each may take action to influence its outcome. The existing literature assumes that there is no net difference between the costs of different actions the agents may take outside the prediction market when external incentives exist. For example, the cost for Alice to work hard to complete the project is the same as it is for her to “loaf” and not work hard. In this work we consider first a two-round and later a four-round setting in which the agents’ costs of external actions differ between actions. We show that a prediction market is incentive-compatible when external action costs differ as long as they remain within a proper range, regardless of the initial market estimate, something that is not shown in the existing literature.