In “Is Manipulation Good for a Prediction Market,” Eric Zitzewitz seeks to counter my view that “Deep Pocketed Manipulators are a Prediction Market’s Friend” by suggesting that even if my argument is correct, manipulators still may be a net bad for prediction markets.

I argued that a manipulator ends up subsidizing the participation of informed traders in the market by putting money on uneconomic positions. Eric responded with three reasons that manipulation nonetheless may tend to undermine prediction markets. In brief (and in my words), he said:

1. People have a distaste for behaviors which violate the spirit of the activity.
2. The possibility of manipulation, and therefore a biased indicator, will lead decision makers to rely on less efficient methods for information gathering.
3. Manipulation makes it harder to understand what is happening in the market – manipulation is harder to decode than noise – because the manipulator actively tries to trick the market.

I suspect Eric is right that many people will instinctively oppose manipulation– even when a manipulator&#8217-s actions comply with the explicit rules of the market, the conduct seems to violate the spirit of the enterprise. The manipulators aren&#8217-t betting that they can out predict you, they don&#8217-t care about out-predicting you, they are just using the market in the attempt to buy a signal for which they have a private value. This violation of the spirit of the enterprise probably strikes most people as just wrong.

I think the best response to instinctive opposition to manipulators is &#8220-get over it&#8221-. Hold your nose if you have to, but take as much of the manipulator’s money as you can. (If it troubles you to take advantage of manipulators this way, consider the public good you are doing by imposing a tax on undesirable behavior.)

Another obvious and useful response is to become more skilled at reading market prices, so as to not be readily fooled. In the face of a dramatic price change, consult other exchanges or the prices in related markets in order to gain context. Deploying such sophistication increases the cost and diminishes the usefulness of price manipulation.

The second and third points Eric makes suggests that the possibility of manipulation will reduce the value of prediction markets and lead decision makers to rely on noisier, but less manipulable tools for information gathering. (E.g., use expert forecasts instead of manipulable prediction markets.) In these cases, manipulation leads to real economic losses.

Useful responses here constitute a research program for the academics and market developers: what effects do various rules have on the potential for manipulation? what effects do the rules have on market efficiency? can manipulation be detected by analysis of trading patterns (perhaps something a prediction market could implement itself), or would more extensive investigations be necessary (likely beyond the capacity of a prediction market)?

Prediction markets, when they work well, create something of value: a price that can serve as a useful probability forecast of future events or conditions. If anyone relies on these prices to make decisions of economic significance, that reliance will create incentives for third parties to influence the prices. On these grounds I think the potential for manipulation is inherent in the enterprise.

So what? To some extent the natural balancing effects of the market will tend to counter manipulation, because manipulation provides a subsidy to participation by informed traders, and informed trading counters manipulation. This process is unlikely to be transparent, however, given that manipulation only works if it is disguised. The best response to the residual prospect of manipulation seems to be to resort to informed-rather-than-naive interpretation of prediction market prices, and research into market rules which may enhance usefulness of prediction markets.