Posted by: Paul Hewitt | November 26, 2009

Is It Enough to Provide Incentives?

In their paper, A Manipulator Can Aid Prediction Market Accuracy, Robin Hanson and Ryan Oprea use a theoretical model to show that a market can become more accurate when manipulators are present, by increasing the returns to informed trading, which provides incentives for traders to become informed.  However, given the number of assumptions made in the model, the authors caution that the “findings may not be robust” and that “since this is not a fully general model, it cannot by itself support strong general claims about the price effects of manipulation.”  So far, so good, we are in complete agreement, at least for some markets!

There are quite a few assumptions in the model, including:  “risk-neutrality, normally distributed values and signal errors, interior choices of information quantity, no transaction costs of trading, no budget constraints, and a single rational manipulator with quadratic manipulation preferences and a commonly known strength of desire to manipulate.”  The authors do examine the potential effects on their conclusions, if some of the assumptions don’t hold true in practice.   Let’s look at some of them.

A Manipulative Conspiracy

For example, if there were a conspiracy among most (maybe “many” would be enough?) traders to pursue a common manipulation objective, the supremacy of the informed over the manipulative traders could be upset.  This isn’t as far-fetched as it may sound.  Large, politically affiliated groups, unions, and industry association groups of members could be inspired to conspire either directly or indirectly (propaganda).

Uninformed by Choice or Constraint

The authors assume that providing an inducement for traders to become better informed, they will actually become better informed. 

What if it is not possible for traders to become sufficiently “informed”?  This could be the result of the issue being too complex or uncertain, or it could be that the cost of becoming sufficiently informed outweighs the benefits of using that information. 

For example, is it even possible for the average bettor to “read up” on climate change research to the extent necessary to determine that the market has been manipulated or that the market reflects too much uninformed, noise trading?  I highly doubt it. 

It could very well be that some issues (like this one) are so complex and so uncertain as to be unpredictable, until very soon before the market closes.  It is only the march of time that whittles away the uncertainty.

Relatively Speaking

The authors state that “when potentially informed traders have deep pockets relative to the volume of noise trading, increases in trading noise do not directly effect price accuracy.”  This assumes that traders can be “informed” and have a sufficient volume relative to noise trade volume (including that of manipulators).  I would argue that a market (such as a climate change PM) does not meet this condition. 

Creating a Prediction out of Nothing

The authors state that “historical, field, and laboratory data, however, have usually failed to find substantial effects of such manipulation on average price accuracy.”  Though this may be true, what happens in a market that has no clear average price (i.e. has a flat distribution)?  Couldn’t a manipulator create a misleadingly “accurate” market price?  The existence of a flat distribution (before manipulation) indicates the market does not have sufficient information to make a prediction.  The traders are uninformed.  Such a market would be ripe for a manipulation, and the market would not have enough informed traders to know what was happening or to do anything about it. 

Conclusion

On balance, I think the authors realize that there is a potential for markets to eliminate the effects of manipulation in some markets, if the necessary conditions and assumptions hold true.  In highly complex, uncertain situations, some of the key assumptions are unlikely to be met, calling into question the conclusion of the paper.  This is what I was trying to get across in my previous post.  Perhaps the single most important condition or assumption in their model is that the informed traders have relatively more trading volume than the noise traders (manipulators).  I explained why I didn’t think this would hold true for all markets.  In the authors’ paper discussed here, they simply state this condition as a fact.   They did warn us, however, that the findings may not be robust or generally applicable to all markets.

One down, three more to go (papers that is).

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Responses

  1. […] Second missile: A critical review of Robin Hanson’s paper, “A Manipulator Can Aid Prediction Market Accu…. Share […]

  2. Paul, a “single” manipulator can represent an ideally well-organized conspiracy. Yes of course if no one can learn more then manipulators won’t induce them to learn more. Flat distributions still have averages. For your purposes, “potentially informed” can include traders uninformed about anything other than the fact that there are manipulators in this market.

  3. If a market yields a flat distribution, there is an average price, but it is not advisable to rely on it, because there is far too much uncertainty.

    If they are uninformed about everything but the fact that there are manipulators in the market, they must seek to find out which way the manipulators are moving the price. I thought I took this position in my earlier post. If I am understanding you, correctly, do you still have a problem with this?

    If traders cannot (feasibly) learn more about a particular issue, shouldn’t we abandon any thoughts of implementing a PM on that issue?

    I think there are some issues that could be implemented, but I also think that the more complex (and important) the issue, the less likely it is that there will be a sufficient number of “informed” traders.

  4. […] big assumption, also identified by Paul Hewitt, is that traders have equal account sizes. But maybe this isn’t a huge problem […]

  5. […] OR… maybe manipulators can game these markets.  I think they can, as explained here, here, here and here.  These references apply to several points that follow regarding manipulation of […]


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