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You are on page 1of 40

**Gaming Prediction Markets: Equilibrium Strategies
**

with a Market Maker

Yiling Chen

1

, Stanko Dimitrov

2

, Rahul Sami

3

, Daniel M. Reeves

4

, David M.

Pennock

4

, Robin D. Hanson

5

, Lance Fortnow

6

, Rica Gonen

7

1

Harvard University, School of Engineering and Applied Sciences, Cambridge, MA

2

University of Michigan, Dept. of Industrial and Operations Engineering, Ann Arbor, MI

3

University of Michigan, School of Information, Ann Arbor, MI

4

Yahoo! Research, New York, NY

5

George Mason University, Department of Economics, Fairfax, VA

6

Northwestern University, EECS Department, Evanston, IL

7

Yahoo! Research, Santa Clara, CA

Received: 2 June 2008 / Accepted: 29 April 2009

Abstract We study the equilibrium behavior of informed traders interacting with

market scoring rule (MSR) market makers. One attractive feature of MSR is that it

is myopically incentive compatible: it is optimal for traders to report their true be-

liefs about the likelihood of an event outcome provided that they ignore the impact

of their reports on the proﬁt they might garner from future trades. In this paper, we

analyze non-myopic strategies and examine what information structures lead to

truthful betting by traders. Speciﬁcally, we analyze the behavior of risk-neutral

traders with incomplete information playing in a dynamic game. We consider

ﬁnite-stage and inﬁnite-stage game models. For each model, we study the log-

arithmic market scoring rule (LMSR) with two different information structures:

conditionally independent signals and (unconditionally) independent signals. In

the ﬁnite-stage model, when signals of traders are independent conditional on the

state of the world, truthful betting is a Perfect Bayesian Equilibrium (PBE). More-

over, it is the unique Weak Perfect Bayesian Equilibrium (WPBE) of the game.

In contrast, when signals of traders are unconditionally independent, truthful bet-

ting is not a WPBE. In the inﬁnite-stage model with unconditionally independent

signals, there does not exist an equilibrium in which all information is revealed

in a ﬁnite amount of time. We propose a simple discounted market scoring rule

that reduces the opportunity for blufﬁng strategies. We show that in any WPBE for

**Preliminary versions of some of the results in this paper were presented in two
**

conference papers, Chen et al. [10] and Dimitrov and Sami [13].

This is an author-created version. The original publication is available at

www.springerlink.com. DOI 10.1007/s00453-009-9323-2.

2 Y. Chen et al.

the inﬁnite-stage market with discounting, the market price converges to the fully-

revealing price, and the rate of convergence can be bounded in terms of the dis-

counting parameter. When signals are conditionally independent, truthful betting

is the unique WPBE for the inﬁnite-stage market with and without discounting.

Key words Prediction markets, game theory, blufﬁng, strategic betting

1 Introduction

It has long been observed that, because market prices are inﬂuenced by all the

trades taking place, they reﬂect the combined information of all the traders. The

strongest form of the efﬁcient markets hypothesis [14] posits that information is

incorporated into prices fully and immediately, as soon as it becomes available to

anyone. A prediction market is a ﬁnancial market speciﬁcally designed to take ad-

vantage of this property. For example, to forecast whether a product will launch on

time, a company might ask employees to trade a security that pays $1 if and only

if the product launches by the planned date. Everyone from managers to develop-

ers to administrative assistants with different forms and amounts of information

can bet on the outcome. The resulting price constitutes their collective probability

estimate that the launch will occur on time. Empirically, such prediction markets

outperform experts, group consensus, and polls across a variety of settings [16, 17,

28, 3, 4, 18, 31, 12, 8].

Yet the double-sided auction at the heart of nearly every prediction market is

not incentive compatible. Information holders do not necessarily have incentive to

fully reveal all their information right away, as soon as they obtain it. The extreme

case of this is captured by the so-called no trade theorems [26]: When rational,

risk-neutral agents with common priors interact in an unsubsidized (zero-sum)

market, the agents will not trade at all, even if they have vastly different informa-

tion and posterier beliefs. The informal reason is that any offer by one trader is

a signal to a potential trading partner that results in belief revision discouraging

trade.

The classic market microstructure model of a ﬁnancial market posits two types

of traders: rational traders and noise traders [24]. The existence of noise traders

turns the game among rational traders into a positive-sum game, thereby resolving

the no-trade paradox. However, even in this setting, the mechanism is not incen-

tive compatible. For example, monopolist information holders will not fully reveal

their information right away: instead, they will leak their information into the mar-

ket gradually over time to obtain a greater proﬁt [7].

Instead of assuming or subsidizing noise traders, a prediction market designer

might choose to directly subsidize the market by employing an automated mar-

ket maker that expects to lose money. Hanson’s market scoring rule market maker

(MSR) is one example [20, 21]. MSR requires a patron to subsidize the market but

guarantees that the patron cannot lose more than a ﬁxed amount set in advance,

regardless of how many shares are exchanged or what outcome eventually occurs.

The greater the subsidy, the greater the effective liquidity of the market. Since

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 3

traders face a positive-sum game, even rational risk-neutral agents have incentive

to participate. In fact, even a single trader can be induced to reveal information,

something impossible in a standard double auction with no market maker. Hanson

proves that myopic risk-neutral traders have incentive to reveal all their informa-

tion. However, forward-looking traders may not.

Though subsidized market makers improve incentives for information reve-

lation, the mechanisms are still not incentive compatible. Much of the allure of

prediction markets is the promise to gather information from a distributed group

quickly and accurately. However, if traders have demonstrable incentives to ei-

ther hide or falsify information, the accuracy of the resulting forecast may be in

question. One frequent concern about incentives in prediction markets is based on

non-myopic strategies: strategies in which the attacker sacriﬁces some proﬁt early

in order to mislead other traders, and then later exploit erroneous trades by other

traders, thereby gaining an overall proﬁt.

1.1 Our Results

In this paper, we study strategies under a logarithmic market scoring rule (LMSR)

in a Bayesian extensive-form game setting with incomplete information. We show

that different information structures can lead to radically different strategic prop-

erties by analyzing two natural classes of signal distributions: conditionally inde-

pendent signals and unconditionally independent signals.

For conditionally independent signals, we show that truthful betting is a Per-

fect Bayesian Equilibrium in ﬁnite-stage and inﬁnite-stage models. Further, we

show that the truthful betting equilibrium is the unique Weak Perfect Bayesian

Equilibrium in this setting. Thus, blufﬁng strategies are not a concern.

In contrast, when signals are unconditionally independent, we show that truth-

ful betting is not a Weak Perfect Bayesian Equilibrium in the ﬁnite-stage model.

In the inﬁnite-stage model, we show that there is no Weak Perfect Bayesian Equi-

librium that results in full information revelation in a ﬁnite number of trades. We

propose and analyze a discounted version of the LMSR that mitigates the strategic

hazard. In the discounted LMSR, we prove that under any WPBE strategy, the rela-

tive entropy between the market price and the optimal full-information price tends

to zero at an exponential rate. The rate of convergence can be bounded in terms of

the discounting parameter and a measure of complementarity in the information

setting.

1.2 Related Work

Theoretical work on price manipulation in ﬁnancial markets [1, 7, 23] explains the

logic of manipulation and indicates that double auctions are not incentive compat-

ible. This literature has studied manipulation based on releasing false information

(perhaps through trades in other markets), as well as manipulation that only re-

quires strategic manipulation in a single market. The latter form of manipulation

is closely related to our study here. Allen and Gale [1] describe a model in which

4 Y. Chen et al.

a manipulative trader can make a deceptive trade in an early trading stage and then

proﬁt in later stages, even though the other traders are aware of the possibility of

deception and act rationally. They use a stylized model of a multi-stage market; in

contrast, we seek to exactly model a market scoring rule model. Apart from other

advantages of detailed modeling, this allows us to construct simpler examples of

manipulative scenarios: Allen and Gale’s model [1] needs to assume traders with

different risk attitudes to get around no-trade results, which is rendered unneces-

sary by the inherent subsidy with a market scoring rule mechanism. Our model

requires only risk-neutral traders and exactly captures the market scoring rule pre-

diction markets. We refer readers to the paper by Chakraborty and Yilmaz [7] for

references to other research on manipulation in ﬁnancial markets.

There are some experimental and empirical studies on price manipulation in

prediction markets using double auction mechanisms. The results are mixed, some

giving evidence for the success of price manipulation [19] and some showing the

robustness of prediction markets to price manipulation [6, 22, 29, 30].

Feigenbaum et al. [15] also study prediction markets in which the information

aggregation is sometimes slow, and sometimes fails altogether. In their setting, the

aggregation problems arise from a completely different source: the traders are non-

strategic but extracting individual traders’ information from the market price is dif-

ﬁcult. Here, we study scenarios in which extracting information from prices would

be easy if traders were not strategic; the complexity arises solely from the use of

potentially non-myopic strategies. Nikolova and Sami [27] present an instance in

which myopic strategies are not optimal in an extensive-form game based on the

market, and suggest (but do not analyze) using a form of discounting to reduce

manipulative possibilities in a prediction market.

Axelrod et al. [2] also propose a form of discounting in an experimental

parimutuel market and show that it promotes early trades. Unlike the parimutuel

market, the market scoring rule has an inherent subsidy, so it was not obvious that

discounting would have strategic beneﬁts in our setting as well.

B¨ orgers et al. [5] study when signals are substitutes and complements in a

general setting. Our equilibrium and convergence result suggests that prediction

markets are one domain where this distinction is of practical importance.

This paper is a synthesis and extension of two independent sets of results,

which were presented in preliminary form by Chen et al. [10] and Dimitrov and

Sami [13].

1.3 Structure of the Paper

This article is organized as follows: In section 2, we present a little background

information about market scoring rules. Section 3 details our formal model and

information structures. In Section 4 we investigate how predeﬁned sequence of

play affects players’ expected proﬁts in LMSR. In Section 5 we consider, when

a player can choose to play ﬁrst or second, what is its equilibrium strategy in

a 2-player LMSR. Results of Sections 4 and 5 serve as building blocks for our

analysis in subsequent sections. Section 6 studies the equilibrium of a 2-player,

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 5

3-stage game. We generalize this result to arbitrary ﬁnite-player ﬁnite-stage games

in Section 7. We analyze inﬁnite-stage games in Section 8. Section 9 proposes

a discounted LMSR and analyzes how the mechanism discourages non-truthful

behavior. Finally, we conclude in Section 10.

2 Background

Consider a discrete random variable X that has n mutually exclusive and ex-

haustive outcomes. Subsidizing a market to predict the likelihood of each out-

come, market scoring rules are known to guarantee that the market maker’s loss is

bounded.

2.1 Market Scoring Rules

Hanson [20, 21] shows how a proper scoring rule can be converted into a market

maker mechanism, called market scoring rules (MSR). The market maker uses a

proper scoring rule, S = {s

1

(r), . . . , s

n

(r)}, where r = r

1

, . . . , r

n

is a reported

probability estimate for the random variable X. Conceptually, every trader in the

market may change the current probability estimate to a new estimate of its choice

at any time as long as it agrees to pay the scoring rule payment associated with the

current probability estimate and receive the scoring rule payment associated with

the new estimate. If outcome i is realized, a trader that changes the probability

estimate from r to ˜r pays s

i

(r) and receives s

i

(˜r).

Since a proper scoring rule is incentive compatible for risk-neutral agents, if a

trader can only change the probability estimate once, this modiﬁed proper scoring

rule still incentivizes the trader to reveal its true probability estimate. However,

when traders can participate multiple times, they might have incentive to manipu-

late information and mislead other traders.

Because traders change the probability estimate in sequence, MSR can be

thought of as a sequential shared version of the scoring rule. The market maker

pays the last trader and receives payment from the ﬁrst trader. An MSR market

can be equivalently implemented as a market maker offering n securities, each

corresponding to one outcome and paying $1 if the outcome is realized [20, 9].

Hence, changing the market probability of outcome i to some value r

i

is the same

as buying the security for outcome i until the market price of the security reaches

r

i

. Our analysis in this paper is facilitated by directly dealing with probabilities.

A popular MSR is the logarithmic market scoring rule (LMSR) where the

logarithmic scoring rule

s

i

(r) = b log(r

i

) (b > 0), (1)

is used. A trader’s expected proﬁt in LMSR directly corresponds to the concept

of relative entropy in information theory. If a trader with probability ˜r moves the

market probability from r to ˜r, its expected proﬁt (score) in LMSR is

S(r, ˜r) =

n

¸

i=1

˜ r

i

(s

i

(˜r) −s

i

(r)) = b

n

¸

i=1

˜ r

i

log

˜ r

i

r

i

= bD(˜r||r). (2)

6 Y. Chen et al.

D(p||q) is the relative entropy or Kullback Leibler distance between two proba-

bility mass functions p(x) and q(x) and is deﬁned in [11] as

D(p||q) =

¸

x

p(x) log

p(x)

q(x)

.

D(p||q) is nonnegative and equals zero only when p = q. The maximum amount

a LMSR market maker can lose is b log n. Since b is a scaling parameter, without

loss of generality we assume that b = 1 in the rest of the paper.

2.2 Terminology

Truthful betting (TB) for a player in MSR is the strategy of immediately changing

the market probability to the player’s believed probability. In other words, it is the

strategy of always buying immediately when the price is too low and selling when

the price is too high. “Too low” and “too high” are determined by the player’s in-

formation. The price is too low when the current expected payoff is higher than the

price, and too high when current expected payoff is lower than the price. Truthful

betting fully reveals a player’s payoff-relevant information. Blufﬁng is the strategy

of betting contrary to one’s information in order to deceive future traders, with

the intent of capitalizing on their resultant misinformed trading. This paper inves-

tigates scenarios where traders with incomplete information have an incentive to

deviate from truthful betting.

1

3 LMSR in a Bayesian Framework

In this part, we introduce our game theoretic model of LMSR market in order to

capture the strategic behavior in LMSR when players have private information.

3.1 General Settings

We consider a single event that is the subject of our predictions. Ω = {Y, N} is

the state space of this event. The true state, ω ∈ Ω, is picked by nature according

to a prior p

0

= p

0

Y

, p

0

N

= Pr(ω = Y ), Pr(ω = N). A market, aiming at

predicting the true state ω, uses a LMSR market maker with initial probability

estimate r

0

= r

0

Y

, r

0

N

.

There are m risk neutral players in the market. Each player i gets a private

signal, c

i

, about the state of the world at the beginning of the market. C

i

is the

signal space of player i with |C

i

| = n

i

. The actual realization of the signal is

observed only by the player receiving the signal. The joint distribution of the true

state and players’ signals, P : Ω×C

1

×· · ·×C

m

→ [0, 1], is common knowledge.

1

With complete information, traders should reveal all information right away in MSR,

because the market degenerates to a race to capitalize on the shared information ﬁrst.

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 7

Players trade sequentially, in one or more stages of trading, in the LMSR mar-

ket. Players are risk-neutrual Bayesian agents. If a player i is designated to trade

at some stage k in the sequence, it can condition its beliefs of the likelihood of an

outcome on its private signals, as well as the observed prices after the ﬁrst k − 1

trades.

Up to this point, we have not made any assumptions about the joint distribution

P. It turns out that the strategic analysis of the market depends critically on inde-

pendence properties of players’ signals. We study two models of independence –

independence conditional on the true state, and unconditional independendence –

that are both natural in different settings. These are described below.

3.1.1 Games with Conditionally Independent (CI) Signals We start with a con-

crete example before formally introducing the model for conditionally independent

signals. Suppose the problem for a prediction market is to predict whether a batch

of product is manufactured with high quality materials or low quality materials. If

the product is manufactured with high quality materials, the probability for a prod-

uct to break in its ﬁrst month of use is 0.01. If the product is manufactured with

low quality materials, the probability for a product to break in its ﬁrst month of

use is 0.1. Some consumers who each bought a product have private observations

of whether their products break in the ﬁrst month of use. The quality of the mate-

rials will be revealed by a test in the future. This is an example where consumers

have conditionally independent signals – conditional on the quality of the materi-

als, consumers’ observations are independent. Conditionally independent signals

are usually appropriate for modeling situations where the true state of the world

has been determined but is unknown, and signal realizations are inﬂuenced by the

true state of the world.

Formally, in games with conditionally independent signals, players’ signals are

assumed to be independent conditional on the state of the world, i.e., conditioned

on the eventual outcome of the event. In other words, for any two players i and j,

Pr(c

i

, c

j

|ω) = Pr(c

i

|ω) Pr(c

j

|ω) is always satisﬁed by P. This class can be inter-

preted as player i’s signal c

i

is independently drawn by nature according to some

conditional probability distribution p

(c

i

|Y )

if the true state is Y , and analogously

p

(c

i

|N)

if the true state is N.

In order to rule out degenerated cases, we further assume that conditionally

independent signals are informative and distinct. An informative signal means that

after observing the signal, a player’s posterior is different from its prior. Intuitively,

when observing a signal does not change a player’s belief, we can simply remove

the signal from the player’s signal space because it does not provide any infor-

mation. Formally, signals are informative if and only if Pr(c

i

= a|ω = Y ) =

Pr(c

i

= a|ω = N), ∀1 ≤ i ≤ m and ∀a ∈ C

i

. Player i has distinct signals

when its posterior probability is different after observing different signals.When

two signals give a player the same posterior, we can combine these two signals

into one because they provide same information. Formally, signals are distinct if

and only if Pr(ω = Y |c

i

= a) = Pr(ω = Y |c

i

= a

), ∀a, a

∈ C

i

, a = a

, and

∀i.

8 Y. Chen et al.

Lemma 1 shows that conditional independence implies unconditional depen-

dence.

Lemma 1 If players have informative signals that are conditionally independent,

their signals are unconditionally dependent.

Proof Suppose the contrary, signals of players i and j, c

i

and c

j

, are uncondition-

ally independent. Then, Pr(c

i

= a, c

j

= b) −Pr(c

i

= a) Pr(c

j

= b) = 0 must be

satisﬁed for all a ∈ C

i

and b ∈ C

j

. By conditional independence of signals,

Pr(c

i

= a, c

j

= b) −Pr(c

i

= a) Pr(c

j

= b)

=

¸

z

Pr(c

i

= a, c

j

= b|ω = z) Pr(ω = z)

−

¸

z

Pr(c

i

= a|ω = z) Pr(ω = z)

¸

z

Pr(c

j

= b|ω = z) Pr(ω = z)

=

¸

z

Pr(c

i

= a|ω = z) Pr(c

j

= b|ω = z) Pr(ω = z)

−

¸

z

Pr(c

i

= a|ω = z) Pr(ω = z)

¸

z

Pr(c

j

= b|ω = z) Pr(ω = z)

= Pr(Y ) Pr(N) (Pr(c

i

= a|Y ) −Pr(c

i

= a|N)) (Pr(c

j

= b|Y ) −Pr(c

j

= b|N)) .

The above expression equals 0 only when Pr(c

i

= a|Y ) − Pr(c

i

= a|N) = 0 or

Pr(c

j

= b|Y ) −Pr(c

j

= b|N) = 0 or both, which contradicts the informativeness

of signals. Hence, c

i

and c

j

are unconditionally dependent.

3.1.2 Games with (Unconditionally) Independent (I) Signals In some other situ-

ations, signal realizations are not caused by the state of the world, but instead, they

might stochastically inﬂuence the eventual outcome of the event. For instance,

in a political election prediction market, voters’ private information is their votes,

which can arguably be thought as independent of each other. The election outcome

– which candidate gets the majority of votes – is determined by all votes. This is

an example of a game with unconditionally independent signals. Formally, for any

two players i and j in games with independent signals, Pr(c

i

, c

j

) = Pr(c

i

) Pr(c

j

)

is always satisﬁed by P.

For games with independent signals, we primarily prove results about the lack

of truthful equilibria. Such results require us to show that there is a strict advan-

tage to deviate to an alternative strategy. In order to rule out degenerate cases in

which the inequalities are not strict, we will often invoke the following general

informativeness condition.

Deﬁnition 1 An instance of the prediction market with m players and joint dis-

tribution P satisﬁes the general informativeness condition if there is no vector of

signals for any m− 1 players that makes the m

th

player’s signals reveal no dis-

tinguishing information about the optimal probability. Formally, for m = 2, the

following property must be true: ∀i, i

∈ C

1

and ∀j, j

∈ C

2

such that i = i

, j =

j

: Pr(Y |c

1

= i, c

2

= j) = Pr(Y |c

1

= i, c

2

= j

) and Pr(Y |c

1

= i, c

2

=

j) = Pr(Y |c

1

= i

, c

2

= j). For m > 2, we must have ∀j, ∀i

= i, Pr(Y |i, j) =

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 9

Pr(Y |i

, j), where i, i

**are two possible signals for any one player, and j is a vector
**

of signals for the other m−1 players.

By Lemma 1, we know that unconditional independence implies conditional

dependence. We note that the two information structures, conditional indepen-

dence and unconditional independence, that we discuss in this paper are mutually

exclusive, but not exhaustive. We do not consider the case when signals are both

conditionally dependent and unconditionally dependent.

3.2 Equilibrium Concepts

The prediction market model we have described is an extensive-form game be-

tween m players with common prior probabilities but asymmetric information

signals. Specifying a plausible play of the game involves specifying not just the

moves that players make for different information signals, but also the beliefs that

they have at each node of the game tree.

Informally, an assessment A

i

= (σ

i

, µ

i

) for a player i consists of a strategy

σ

i

and a belief system µ

i

. The strategy dictates what move the player will make at

each node in the game tree at which she has to move. We allow for strategies to

be (behaviorally) mixed; indeed, a blufﬁng equilibrium must involve mixed strate-

gies. To avoid technical measurability issues, we make the mild assumption that a

player’s strategy can randomize over only a ﬁnite set of actions at each node. The

belief system component of an assessment speciﬁes what a player believes at each

node of the game tree. In our setting, the only relevant information a trader lacks

is the value of the other trader’s information signal. Thus, the belief at a node con-

sists of probabilities of other players’ signal realizations, contingent on reaching

the node.

An assessment proﬁle (A

1

, ..., A

m

), consisting of an assessment for each

player, is a Weak Perfect Bayesian Equilibrium (WPBE) if and only if, for each

player, the strategies are sequentially rational given their beliefs and their beliefs

at any node that is reached with nonzero probability are consistent with updating

their prior beliefs using Bayes rule, given the strategies. This is a relatively weak

notion of equilibrium for this class of games. Frequently, the reﬁned concepts of

Perfect Bayesian Equilibrium (PBE) or sequential equilibrium, which further re-

quire beliefs at nodes that are off the equilibrium path to be consistent, are used.

In this paper, when giving a speciﬁc equilibrium, we use the reﬁned PBE concept.

When proving the nonexistence of truthful betting equilibrium and characterizing

the set of all equilibria, we use the WPBE concept, because the results thus hold

a fortiori for reﬁnements of the WPBE concept. For a formal deﬁnition of the

equilibrium concepts, we refer the reader to the book by Mas-Colell et al. [25].

Given the strategy components of a WPBE proﬁle, the belief systems of the

players are completely deﬁned at every node on the equilibrium path (i.e., every

node that is reached with positive probability). In the remainder of this paper, we

will not consider players’ beliefs off the equilibrium path for WPBEs. We will

abuse notation slightly by simply referring to an “equilibrium strategy proﬁle”,

10 Y. Chen et al.

leaving the beliefs implicit, for WPBEs. For PBEs, we will explicitly explain play-

ers’ beliefs in proofs.

4 Proﬁts under Predeﬁned Sequence of Play

In this section, we investigate how sequence of play affects players’ expected prof-

its in LMSR. We answer the question: when two players play myopically accord-

ing to a predeﬁned sequence of play, are the players better off on expectation by

playing ﬁrst or second?

In particular, we consider two players playing in sequence and deﬁne some

notations of strategy and expected proﬁts to facilitate our analysis on how the

proﬁt of the second player depends on the strategy employed by the ﬁrst player.

Although we are studying 2-stage games here, we use them as a building block for

our results in subsequent sections, so the deﬁnitions are more general and the ﬁrst

player’s strategy may not be truthful. In fact, our analysis apply to the ﬁrst two

stages of any game.

Deﬁnition 2 Given a game and a sequence of play, a ﬁrst-stage strategy σ

1

for

the ﬁrst player is a speciﬁcation, for each possible signal received by that player,

of a mixed strategy over moves.

Two speciﬁc ﬁrst-stage strategies we will study are the truthful strategy (de-

noted σ

T

) and the null strategy (denoted σ

N

). The truthful strategy speciﬁes that,

for each signal c

i

it receives, the ﬁrst player changes market probability to its pos-

terior belief after seeing the signal. The null strategy speciﬁes that, regardless of

its signal c

i

, the ﬁrst player leaves the market probability unchanged, the same as

she found it at.

In a 2-stage game in which Alice plays ﬁrst, followed by Bob, we use notation

π

B

(σ

1

) to denote Bob’s expected myopic optimal proﬁt following a ﬁrst-stage

strategy σ

1

by Alice, assuming that Bob knows the strategy σ

1

and can condition

on it. Likewise, in a game in which Alice moves after Bob, we use π

A

(σ

1

) to

denote Alice’s expected proﬁt.

Note that π

B

(σ

N

) is equal to the expected myopic proﬁt Bob would have had

if he had moved ﬁrst, because under the null strategy σ

N

Alice does not move

the market. Also, π

B

(σ

T

) is the proﬁt that Bob earns when Alice follows her

myopically optimal strategy.

We begin with the following simple result showing that the truthful strategy is

optimal for a player moving only once. This follows from the myopic optimality

of LMSR, but we include a proof for completeness.

Lemma 2 In a LMSR market, if stage t is player i’s last chance to play and

µ

i

is player i’s belief over actions of previous players, player i’s best response

at stage t is to play truthfully by changing the market probabilities to r

t

=

Pr(Y |c

i

, r

1

, ..., r

t−1

, µ

i

), Pr(N|c

i

, r

1

, ..., r

t−1

, µ

i

), where r

1

, ..., r

t−1

are the

market probability vectors before player i’s action.

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 11

Proof When a player has its last chance to play in LMSR, it is the same as the

player interacting with a logarithmic scoring rule. Because the logarithmic scor-

ing rule is strictly proper, player i’s expected utility is maximized by truthfully

reporting its posterior probability estimate given the information it has.

Next, we provide a lemma that is very useful for obtaining subsequent theo-

rems. Since the state of the world has only two exclusive and exhaustive outcomes,

Y and N. We use the term position to refer the market probability for outcome Y .

The market probability for outcome N is then uniquely deﬁned because the prob-

abilities for the two outcomes sum to 1.

Lemma 3 Let σ

1

be a ﬁrst-stage strategy for Alice that minimizes the expression

π

B

(σ) over all possible σ. Then, σ

1

satisﬁes the following consistency condition:

For any position x that Alice moves to under σ

1

, the probability of the outcome Y

occuring conditioned on σ

1

and the fact that Alice moved to x is exactly equal to

x.

Proof Suppose that σ

1

does not satisfy this condition. We construct a perturbed

ﬁrst-stage strategy ˆ σ

1

, and show that π

B

(ˆ σ

1

) < π

B

(σ

1

), thus contradicting the

minimality of σ

1

. Such a ˆ σ

1

is easily constructed from any given σ

1

, as follows.

We start by setting ˆ σ

1

= σ

1

. Consider any one position x that Alice moves to with

positive probability under strategy σ

1

, and for which the consistency condition is

failed. Let q

x

= Pr(Y |x

A

= x, Alice following σ

1

). Then, whenever σ

1

dictates

that Alice move to x, we set ˆ σ

1

to dictate that Alice move to ˆ x = q

x

instead. We

repeat this perturbation for each x such that x = q

x

, thus resulting in a consistent

strategy ˆ σ

1

.

The actual position that Alice moves to can be thought of as a random variable

on a sample space that includes the randomly-distributed signals Alice receives as

well as the randomization Alice uses to play a mixed strategy. We use x

A

and ˆ x

A

to denote random variables that takes on values x and ˆ x respectively. Similarly,

the event ω is a random variable that takes on two values {Y, N}. Recall that the

moves are actually probability distributions. In order to use summation notation,

we deﬁne x

Y

= x, x

N

= 1 − x; and, likewise, ˆ x

Y

= ˆ x, ˆ x

N

= 1 − ˆ x. By

deﬁnition of ˆ x, ˆ x

z

= Pr(ω = z|x

A

= ˆ x, Alice following ˆ σ

1

). Note that any x has

a corresponding value of ˆ x; thus, we may write expressions like

¸

x

ˆ x in which

ˆ x is implicitly indexed by x. We use Pr(x, b, z) to represent Pr(x

A

= x, c

B

=

b, ω = z), and other notation is deﬁned similarly.

The intuitive argument we use is as follows: Consider the situation in which

Alice is known to be following strategy σ

1

. The total proﬁt of two consecutive

moves, in a market using the LMSR, is exactly the payoff of moving from the

starting point to the end point of the second move. Hence, for any given position

x that Alice leaves the market price at, we decompose Bob’s response into two

virtual steps. In the ﬁrst virtual step, Bob moves the market to the corresponding

ˆ x. In the second step, Bob moves the market from ˆ x to his posterior probability

Pr(z|x, b). Bob’s actual proﬁt is the sum of his proﬁt from these two steps. Note

that the second step alone yields Bob at least π

B

(ˆ σ

1

) in expectation, because in

both cases the move begins at ˆ x, and because Bob can infer ˆ x from x. We further

argue that the ﬁrst step yields a strictly positive expected proﬁt, because for any

12 Y. Chen et al.

position x, the posterior probability of outcome Y is ˆ x

Y

. The ﬁrst step thus moves

the market from a less accurate value to the most accurate possible value given

information x; this always yields a positive expected proﬁt in the LMSR.

Formalizing this argument, we compare the payoffs π

B

(σ

1

) and π

B

(ˆ σ

1

) as

follows.

π

B

(σ

1

) −π

B

(ˆ σ

1

) =

¸

x,b,z

Pr(x, b, z) [log Pr(z|x, b) −log x

z

]

−

¸

x,b,z

Pr(x, b, z) [log Pr(z|ˆ x, b) −log ˆ x

z

]

=

¸

x,b,z

Pr(x, b, z) [log Pr(z|x, b) −log Pr(z|ˆ x, b)]

+

¸

x,b,z

Pr(x, b, z) [log ˆ x

z

−log x

z

]

=

¸

x,b

Pr(x, b)

¸

z

Pr(z|x, b) [log Pr(z|x, b) −log Pr(z|ˆ x, b)]

+

¸

x

Pr(x)

¸

z

Pr(z|x) [log ˆ x

z

−log x

z

]

=

¸

x,b

Pr(x, b)D(p

(ω|x

A

,c

B

)

||p

(ω|ˆ x

A

,c

B

)

)

+

¸

x

Pr(x)

¸

z

ˆ x

z

[log ˆ x

z

−log x

z

]

=

¸

x,b

Pr(x, b)D(p

(ω|x

A

,c

B

)

||p

(ω|ˆ x

A

,c

B

)

)

+

¸

x

Pr(x)D(p

(ˆ x

A

)

||p

(x

A

)

)

where p

(ω|x

A

,c

B

)

and p

(ω|ˆ x

A

,c

B

)

are the conditional distributions of ω, and

p

(ˆ x

A

)

and p

(x

A

)

are the probability distributions of ˆ x

A

and x

A

respectively.

D(p

(ω|x

A

,c

B

)

||p

(ω|ˆ x

A

,c

B

)

) and D(p

(ˆ x

A

)

||p

(x

A

)

) are relative entropy, which is

known to be nonnegative and strictly positive when the two distributions are

not the same. We assumed that σ

1

does not meet the consistency condition, and

thus, there is at least one x such that Pr(x) > 0 and ˆ x = x. Thus, we have

D(p

(ˆ x

A

)

||p

(x

A

)

) > 0. Hence, π

B

(σ

1

) > π

B

(ˆ σ

1

). This contradicts the minimality

assumption of σ

1

.

4.1 Proﬁts in CI Games

When Alice and Bob have conditionally independent signals and Alice plays ﬁrst,

we will prove that, for any strategy σ

1

that Alice chooses, if Bob is aware that Alice

is following strategy σ

1

, his expected payoff from following the myopic strategy

(after conditioning his beliefs on Alice’s actual move) is at least as much as he

could expect if Alice had chosen to play truthfully.

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 13

First, we show that in CI games, observing Alice’s posterior probabilities is

equally informative to Bob as observing Alice’s signal directly.

Lemma 4 When players have conditionally independent signals, if player i knows

player j’s posterior probabilities Pr(Y |c

j

), Pr(N|c

j

), player i can infer the pos-

terior probabilities conditional on both signals. More speciﬁcally,

Pr(ω|c

i

, c

j

) =

Pr(c

i

|ω) Pr(ω|c

j

)

Pr(c

i

|Y ) Pr(Y |c

j

) + Pr(c

i

|N) Pr(N|c

j

)

,

where ω ∈ {Y, N}.

Proof Using Bayes rule, we have

Pr(ω|c

i

, c

j

) =

Pr(ω, c

i

|c

j

)

Pr(c

i

|c

j

)

=

Pr(c

i

|c

j

, ω) Pr(ω|c

j

)

Pr(c

i

|c

j

, Y ) Pr(Y |c

j

) + Pr(c

i

|c

j

, N) Pr(N|c

j

)

=

Pr(c

i

|ω) Pr(ω|c

j

)

Pr(c

i

|Y ) Pr(Y |c

j

) + Pr(c

i

|N) Pr(N|c

j

)

.

The third equality comes from the CI condition.

We can now prove our result on Bob’s myopic proﬁt in the CI setting.

Theorem 1 For any CI game G with Alice playing ﬁrst and Bob playing second,

and any σ

1

, π

B

(σ

1

) ≥ π

B

(σ

T

). When signals are informative and distinct, the

equality holds if and only if σ

1

= σ

T

.

Proof We use an information-theoretic argument to prove this result. We can view

Alice’s signal c

A

, Alice’s actual move x

A

(for outcome Y ) , Bob’s signal c

B

, the

event ω as random variables. We then show that Bob’s expected payoff can be

characterized as the entropy of c

B

conditioned on observing x

A

, plus another term

that does not depend on Alice. The more information that x

A

reveals about c

B

,

the lower the conditional entropy H(c

B

|x

A

), and thus, the lower Bob’s expected

proﬁt. However, note that x

A

is a (perhaps randomized) function of Alice’s signal

c

A

alone. A fundamental result from information theory states that x

A

can reveal

no more information about c

B

than c

A

can, and thus, Bob’s proﬁt is minimized

when x

A

reveals as much information as c

A

. By Lemma 4, the truthful strategy

for Alice reveals all information that is in c

A

, and thus, attains the minimum.

We now formalize this argument, retaining the notation above. By Lemma 3,

we can assume that σ

1

is consistent, without loss of generality. Let us analyze

Bob’s expected payoff when Alice follows this strategy σ

1

. The unit of our analysis

is a particular realization of a combination c

A

= a, x

A

= x, c

B

= b, ω = z. Bob

will move to a position y(x, σ

1

, b) = Pr(Y |x

A

= x, Alice following σ

1

, c

B

= b).

For conciseness, we drop σ

1

from the notation, and write y(x, b).

As before use x

z

and y

z

to denote the probability of ω = z inferred from

positions x and y respectively. By deﬁnition of the LMSR, we have:

π

B

(σ

1

) =

¸

x,b,z

Pr(x, b, z) [log y

z

(x, b) −log x

z

]

14 Y. Chen et al.

Next, we note that y

z

(x, b) = Pr(ω = z|x, b). Further, it is immediate that

¸

b

Pr(b|x, z) = 1. Expanding, we have

π

B

(σ

1

) =

¸

x,b

Pr(x, b)

¸

z

Pr(z|x, b) log y

z

(x, b)

−

¸

x

Pr(x)

¸

z

Pr(z|x)

¸

b

Pr(b|x, z) log x

z

=

¸

x,b

Pr(x, b)

¸

¸

z

Pr(z|x, b) log Pr(z|x, b)

¸

−

¸

x

Pr(x)

¸

¸

z

Pr(z|x) log Pr(z|x)

¸

= −H(ω|x

A

, c

B

) +H(ω|x

A

)

where we have identiﬁed the terms with the standard deﬁnition of conditional en-

tropy of random variables [11, pg. 17].

Using the relation H(X, Y ) = H(X) +H(Y |X), we can write

π

B

(σ

1

) = −H(ω, x

A

, c

B

) +H(x

A

, c

B

) +H(ω, x

A

) −H(x

A

)

= [H(x

A

, c

B

) −H(x

A

)] −[H(ω, x

A

, c

B

) −H(ω, x

A

)]

= H(c

B

|x

A

) −H(c

B

|ω, x

A

)

= H(c

B

|x

A

) −H(c

B

|ω)

The last transformation H(c

B

|ω, x

A

) = H(c

B

|ω) follows because c

B

is condi-

tionally independent of x

A

conditioned on ω, and thus, knowledge of x

A

does not

alter its conditional distribution or its conditional entropy.

The second term is clearly independent of σ

1

. For the ﬁrst term, we note that

H(c

B

|c

A

) ≤ H(c

B

|x

A

) because x

A

is a function of c

A

[11, pg. 35]. More specif-

ically,

H(c

B

|x

A

) = −

¸

x

Pr(x)

¸

¸

b

Pr(b|x) log Pr(b|x)

¸

= −

¸

x

Pr(x)

¸

¸

b

¸

a

Pr(a|x) Pr(b|a)

log

¸

a

Pr(a|x) Pr(b|a)

¸

≥ −

¸

x

Pr(x)

¸

b

¸

a

[Pr(a|x) Pr(b|a) log Pr(b|a)]

= −

¸

x

Pr(x)

¸

a

¸

Pr(a|x)

¸

b

[Pr(b|a) log Pr(b|a)]

¸

= −

¸

a

Pr(a)

¸

¸

b

Pr(b|a) log Pr(b|a)

¸

= H(c

B

|c

A

).

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 15

The inequality follows from the strict convexity of the function xlog x. The

equality holds only when the distribution of c

B

|a is the same as the distribu-

tion of c

B

|a

for all a, a

∈ C

A

, or for any x there exists some a such that

Pr(c

A

= a|x

A

= x) = 1. If c

B

|a and c

B

|a

**have the same distribution for all
**

a and a

, c

A

and c

B

are unconditionally independent which contradicts with the

CI condition by Lemma 1. Thus, the equality holds only when σ

1

is a strategy such

that for any x there exists some a that satisﬁes Pr(c

A

= a|x

A

= x) = 1.

The truthful strategy σ

T

satisﬁes the above condition. Given any signal a that

Alice might see, let x

a

be the position that Alice would move to if she followed the

truthful strategy, and let x

T

A

denote the corresponding random variable. Then x

a

=

Pr(Y |c

A

= a). Because signals are distinct, the value of x

a

uniquely corresponds

to signal a. Hence, the condition is satisﬁed with Pr(c

A

= a|x

T

A

= x

a

) = 1.

All that remains to be shown is that there is no other strategy σ

1

= σ

T

that

satisﬁes the condition. For some strategy σ

1

, let X

A

denote the value space of x

A

.

Suppose the contrary, for any x ∈ X

A

there exists a

x

such that Pr(c

A

= a

x

|x

A

=

x) = 1. We ﬁrst show that when x = x

and x, x

∈ X

A

, it must be that a

x

= a

x

.

According to Lemma 3, Pr(Y |x

A

= x, Alice follows σ

1

) = x, which gives

¸

a

Pr(Y |c

A

= a

) Pr(c

A

= a

|x

A

= x) = x =⇒ Pr(Y |c

A

= a

x

) = x.

This means that Pr(Y |c

A

= a

x

) = Pr(Y |c

A

= a

x

) when x = x

. Hence,

a

x

= a

x

because signals are distinct. Next, we show that when c

A

= a, it must

be the case that x

A

= Pr(Y |c

A

= a) with probability 1 according to strategy

σ

1

. If with some positive probability x

A

= x

= Pr(Y |c

A

= a), then, because

Pr(c

A

= a

x

|x

A

= x

) = 1, c

A

= a

x

= a, and contradiction arises. Thus, for all

a ∈ C

A

, when c

A

= a, Alice moves to Pr(Y |c

A

= a) with probability 1 under

σ

1

. Hence, strategy σ

1

is the truthful strategy σ

T

.

The following corollary immediately follows fromTheorem1 and answers that

question we proposed at the beginning of the section for CI games.

Corollary 1 In CI games, when two players play myopically according to a pre-

deﬁned sequence of play, it is better off for a player to play ﬁrst than second.

Proof We compare Bob’s expected proﬁt in Alice-Bob and Bob-Alice cases when

both players play myopically. Bob’s expected proﬁt in Alice-Bob case equals

π

B

(σ

T

), while his expected proﬁt in Bob-Alice cases equals π

B

(σ

N

). According

to Theorem 1, π

B

(σ

N

) > π

B

(σ

T

). Hence, Bob is better off when the Bob-Alice

sequence is used.

4.2 Proﬁts in I Games

When Alice and Bob have unconditionally independent signals and Alice plays

ﬁrst, we will prove that, for any strategy σ

1

that Alice chooses, if Bob is aware

that Alice is following strategy σ

1

, his expected payoff from following the myopic

strategy (after conditioning his beliefs on Alices actual move) is at least as much

as he could expect if Alice had chosen to play the null strategy σ

N

.

16 Y. Chen et al.

Theorem 2 For any I game G with Alice playing ﬁrst and Bob playing second and

any ﬁrst-stage strategy σ

1

, if the market starts with the prior probabilities for the

two outcomes, i.e. r

0

= Pr(ω = Y ), Pr(ω = N), we have π

B

(σ

1

) ≥ π

B

(σ

N

).

The equality holds if and only if σ

1

= σ

N

.

Proof Assume that there is a strategy σ

1

for Alice that minimizes π

B

(σ

1

) over all

possible ﬁrst-stage strategies. According to Lemma 3, we can assume that σ

1

is

consistent, without loss of generality. We will show that σ

1

must involve Alice not

moving the market probability at all.

Let x

A

be the random variable of Alice’s move for outcome Y under strategy

σ

1

. We ﬁrst argue that x

A

is deterministic, i.e. it can only have a single value.

Suppose the contrary, then σ

1

would have support over a set of points: at least

two points E, F, and perhaps a set of other points R. In this case, we show that

we can construct a strategy σ

1

such that π

B

(σ

1

) < π

B

(σ

1

) by “mixing” point

E and another point H. Deﬁne u

E

i

and u

F

i

as the probability (under σ

1

) that

Alice has signal c

A

= a

i

and sets x

A

= E and x

A

= F respectively. Let p

E

be

the probability that Alice plays E and similarly p

F

be the probability that Alice

plays F. Without loss of generality let p

F

< p

E

. Deﬁne α

i

= Pr(c

A

= a

i

|x

A

=

E) =

u

E

i

p

E

and β

i

= Pr(c

A

= a

i

|x

A

= F) =

u

F

i

p

F

. With these deﬁnitions we

can deﬁne the myopic move of Bob given that market is at E and c

B

= b

j

as

r

α

j

=

¸

i

α

i

Pr(Y |c

A

= a

i

, c

B

= b

j

). Similarly r

β

j

is deﬁned as the myopic

move of Bob given the market is at F. We use r

α

j

and r

β

j

to denote the probability

vectors for two outcomes r

α

j

, 1 −r

α

j

and r

β

j

, 1 −r

β

j

respectively.

Now, let H = (E + F)/2 be the midpoint of E and F, and consider a new

strategy σ

1

over points E, H, and the same set of remaining points R. Under σ

1

,

the probability that Alice has signal c

A

= a

i

and sets x

A

= E is

p

E

−p

F

p

E

u

E

i

, and

the probability that Alice has signal c

A

= a

i

and sets x

A

= H equals

p

F

p

E

u

E

i

+u

F

i

.

Hence, Alice mixes over E and H with probability p

E

−p

F

and 2p

F

respectively.

As before we can deﬁne γ

i

= Pr(c

A

= a

i

|H) =

p

F

p

E

u

E

i

+u

F

i

2p

F

=

1

2

u

E

i

p

E

+

1

2

u

F

i

p

F

=

α

i

+β

i

2

. We can now deﬁne the myopic move of Bob given the market is at H

and c

B

= b

j

as r

γ

j

=

¸

i

γ

i

Pr(Y |c

A

= a

i

, c

B

= b

j

). Similarly, we use r

γ

j

to

represent the vector for two outcomes.

We now characterize π

B

(σ

1

) as follows, writing p

E

as (p

E

− p

F

) + p

F

to

facilitate comparison with π

B

(σ

1

).

π

B

(σ

1

) = (p

E

−p

F

)[

¸

j

Pr(c

B

= b

j

)D(r

α

j

||

¸

j

Pr(c

B

= b

j

)r

α

j

)]

+p

F

[

¸

j

Pr(c

B

= b

j

)D(r

α

j

||

¸

j

Pr(c

B

= b

j

)r

α

j

)]

+p

F

[

¸

j

Pr(c

B

= b

j

)D(r

β

j

||

¸

j

Pr(c

B

= b

j

)r

β

j

)]

+ remaining proﬁt over R

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 17

We also characterize π

B

(σ

1

) as:

π

B

(σ

1

) = (p

E

−p

F

)[

¸

j

Pr(c

B

= b

j

)D(r

α

j

||

¸

j

Pr(c

B

= b

j

)r

α

j

)

+2p

F

[

¸

j

Pr(c

B

= b

j

)D(r

γ

j

||

¸

j

Pr(c

B

= b

j

)r

γ

j

)

+ remaining proﬁt over R

From the deﬁnitions of the myopic moves given the market states, note that r

γ

j

=

r

α

j

+r

β

j

2

. This means that π

B

(σ

1

) can be bounded as :

π

B

(σ

1

) = (p

E

−p

F

)[

¸

j

Pr(c

B

= b

j

)D(r

α

j

||

¸

j

Pr(c

B

= b

j

)r

α

j

)

+2p

F

[

¸

j

Pr(c

B

= b

j

)D(r

γ

j

||

¸

j

Pr(c

B

= b

j

)r

γ

j

)

+ remaining proﬁt over R

= (p

E

−p

F

)[

¸

j

Pr(c

B

= b

j

)D(r

α

j

||

¸

j

Pr(c

B

= b

j

)r

α

j

)

+2p

F

[

¸

j

Pr(c

B

= b

j

)D(

r

α

j

+r

β

j

2

||

¸

j

Pr(c

B

= b

j

)

r

α

j

+r

β

j

2

)

+ remaining proﬁt over R

< (p

E

−p

F

)[

¸

j

Pr(c

B

= b

j

)D(r

α

j

||

¸

j

Pr(c

B

= b

j

)r

α

j

)]

+p

F

[

¸

j

Pr(c

B

= b

j

)D(r

α

j

||

¸

j

Pr(c

B

= b

j

)r

α

j

)]

+p

F

[

¸

j

Pr(c

B

= b

j

)D(r

β

j

||

¸

j

Pr(c

B

= b

j

)r

β

j

)]

+ remaining proﬁt over R

= π

B

(σ

1

)

The last inequality follows from the strict convexity of relative entropy under the

general informativeness condition.

Therefore, for any strategy σ

1

with two or more points in its support, there

always exists a strategy σ

1

such that π

B

(σ

1

) < π

B

(σ

1

). This means that for any

strategy of Alice that minimized π

B

(σ

1

), the strategy must have only one point

in its support. Thus, the strategy does not reveal any information to Bob. Suppose

that the point in the support, x, is such that x = Pr(ω = Y ). This again contradicts

the fact that σ

1

minimizes π

B

(σ

1

), as Bob will always make a positive payoff in

expectation if he moves fromx to Pr(ω = Y ). Thus, he would have a larger payoff

overall if Alice left the market at x instead of Pr(ω = Y ). Therefore the strategy

that minimizes the expected payoff of Bob is for Alice to report Pr(ω = Y ).

However, because the market starts with Pr(ω = Y ), it is equivalent to her not

trading at all in the ﬁrst stage. Therefore we have shown that π

B

(σ

1

) ≥ π

B

(σ

N

).

Only when σ

1

= σ

N

the equality holds.

The following corollary immediately follows from Theorem 2 and answers the

question we proposed at the beginning of the section for I games.

18 Y. Chen et al.

Corollary 2 In I games that start with the prior probabilities for the two out-

comes, i.e. r

0

= Pr(ω = Y ), Pr(ω = N), when two players play myopically

according to a predeﬁned sequence of play, it is better off for a player to play

second than ﬁrst.

Proof We compare Bob’s expected proﬁt in Alice-Bob and Bob-Alice cases when

both players play myopically. Bob’s expected proﬁt in Alice-Bob case equals

π

B

(σ

T

), while his expected proﬁt in Bob-Alice cases equals π

B

(σ

N

). According

to Theorem 2, π

B

(σ

T

) ≥ π

B

(σ

N

). Hence, Bob is better off when the Alice-Bob

sequence is used.

5 Sequence Selection Game

In this section, we examine the following strategic question: Suppose that each

player will get to report only once. If a player has a choice between playing ﬁrst

and playing second after observing its signal, which one should it choose?

To answer the question, we deﬁne a simple 2-player sequence selection game.

Suppose that Alice and Bob are the only players in the market. Alice gets a signal

c

A

. Similarly, Bob gets a signal c

B

. After getting their signals, Alice and Bob play

the sequence selection game as follows. In the ﬁrst stage, Alice chooses who—

herself or Bob—plays ﬁrst. The selected player then changes the market probabil-

ities as they see ﬁt in the second stage. In the third stage, the other player gets the

chance to change the market probabilities. Then, the market closes and the true

state is revealed.

In the rest of this section, we provide equilibria of the sequence selection game

under CI setting and I setting respectively.

5.1 Sequence Selection Equilibrium of CI Games

Consider the sequence selection game, and assume that Alice and Bob have condi-

tionally independent signals. The following theorem gives a PBE of the sequence

selection game when the CI condition is satisﬁed.

Theorem 3 When Alice and Bob have conditionally independent signals in LMSR,

at a PBE of the sequence selection game

– Alice selects herself to be the ﬁrst player in the ﬁrst stage;

– Alice changes the market probability to Pr(Y |c

A

), Pr(N|c

A

) in the second

stage;

– Bob changes the market probability to Pr(Y |c

A

, c

B

), Pr(N|c

A

, c

B

) in the

third stage.

Proof Since we use the PBE concept, we ﬁrst describe Bob’s belief µ

B

for the off-

equilibrium paths. We denote x = x

1

, ..., x

n

A

as the vector of Alice’s possible

posteriors for the outcome Y . That is, x

i

= Pr(Y |c

A

= a

i

), where a

i

is the i-th

element of C

A

. Without loss of generality, assume that x

i

< x

j

iff i < j. Off

the equilibrium path, when Alice selects Bob to be the ﬁrst player and the initial

market probability is r

0

, Bob’s belief µ

B

gives

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 19

– If x

1

≤ r

0

Y

≤ x

n

A

, Pr(Y |r

0

, µ

B

) = r

0

Y

.

– If 0 ≤ r

0

Y

< x

1

, Pr(Y |r

0

, µ

B

) = x

1

.

– If x

n

A

< r

0

Y

≤ 1, Pr(Y |r

0

, µ

B

) = x

n

A

.

Bob’s belief µ

B

is consistent with Alice’s off-equlibrium mixed strategy:

– If c

A

= a

i

and x

i

= r

0

Y

, select Bob as the ﬁrst player.

– If c

A

= a

i

or c

A

= a

i+1

and x

i

< r

0

Y

< x

i+1

, mix between selecting herself

as the ﬁrst player and selecting Bob as the ﬁrst player. When c

A

= a

i

, with

probability α select Bob as the ﬁrst player and (1 − α) select herself as the

ﬁrst player. When c

A

= a

i+1

, with probability β select Bob as the ﬁrst player

and (1 −β) select herself as the ﬁrst player. The mixing probabilities α and β

satisfy that Pr(Y |select Bob as the ﬁrst player) = r

0

Y

.

– If c

A

= a

1

and 0 ≤ r

0

Y

< x

1

, select Bob as the ﬁrst player.

– If c

A

= a

n

A

and x

n

A

< r

0

Y

≤ 1, select Bob as the ﬁrst player.

– For all other cases, select herself as the ﬁrst player.

Each player has only one chance to change the market probabilities. Hence, by

Lemma 2, both of them will truthfully reveal all information that they have given

their beliefs when it’s their turn to play. If Alice is the ﬁrst to play, she will change

the market probabilities to Pr(Y |c

A

), Pr(N|c

A

) in the second stage. Bob, be-

lieving that prices in the second stage are Alice’s posteriors, can calculate his pos-

teriors based on both Alice’s and his own signals. Bob will further changes the

market probabilities to Pr(Y |c

A

, c

B

), Pr(N|c

A

, c

B

) in the third stage. On the

contrary, if Bob is selected as the ﬁrst player, he will change the market probabili-

ties to Pr(Y |r

0

, c

B

, µ

B

), Pr(N|r

0

, c

B

, µ

B

) in the second stage. Let ˆ a

r

0 denote

a ﬁctitious signal realization of Alice that satisﬁes Pr(Y |ˆ a

r

0), Pr(N|ˆ a

r

0) = r

0

.

ˆ a

r

0 does not necessarily belong to Alice’s signal space C

A

. According to Lemma

4, Pr(Y |r

0

, c

B

, µ

B

), Pr(N|r

0

, c

B

, µ

B

) equals one of the following

1. Pr(Y |ˆ a

r

0, c

B

), Pr(N|ˆ a

r

0, c

B

) when x

1

≤ r

0

Y

≤ x

n

A

.

2. Pr(Y |a

n

A

, c

B

), Pr(N|a

n

A

, c

B

) when x

n

A

< r

0

Y

≤ 1.

3. Pr(Y |a

1

, c

B

), Pr(N|a

1

, c

B

) when 0 ≤ r

0

Y

< x

1

.

To make her sequence selection in the ﬁrst stage, Alice essentially compares

her expected utilities conditional on her own signal in the Alice-Bob and Bob-

Alice subgames.

Without loss of generality, suppose Alice has signal a

k

. Let U

I

A

denote Alice’s

expected proﬁt conditioned on her signal when the Alice-Bob subgame is picked.

U

II

A

denotes Alice’s expected proﬁt conditioned on her signal when the Bob-Alice

subgame is picked. Then, for case 1,

U

I

A

=

1

Pr(c

A

= a

k

)

¸

l,z

Pr(a

k

, b

l

, z) log

Pr(ω = z|c

A

= a

k

)

Pr(ω = z|ˆ a

r

0)

, and (3)

U

II

A

=

1

Pr(c

A

= a

k

)

¸

l,z

Pr(a

k

, b

l

, z) log

Pr(ω = z|c

A

= a

k

, c

B

= b

l

)

Pr(ω = z|ˆ a

r

0, c

B

= b

l

)

, (4)

where b

l

represents the l-th signal element in C

B

, and Pr(a

k

, b

l

, z) represents the

joint probability of c

A

= a

k

, c

B

= b

l

, and ω = z. For conciseness, we use Pr(a

k

)

20 Y. Chen et al.

to represent Pr(c

A

= a

k

) and similarly for other terms. The difference in expected

proﬁts for Alice in the two subgames is:

U

I

A

−U

II

A

=

1

Pr(a

k

)

¸

l,z

Pr(a

k

, b

l

, z) log

Pr(z|a

k

) Pr(z|ˆ a

r

0, b

l

)

Pr(z|ˆ a

r

0) Pr(z|a

k

, b

l

)

(5)

=

1

Pr(a

k

)

¸

l,z

Pr(a

k

, b

l

, z) log

Pr(a

k

, b

l

) Pr(ˆ a

r

0)

Pr(ˆ a

r

0, b

l

) Pr(a

k

)

=

¸

l

Pr(b

l

|a

k

) log

Pr(b

l

|a

k

)

Pr(b

l

|ˆ a

r

0)

= D

p

(c

B

|a

k

)

||p

(c

B

|ˆ a

r

0)

, (6)

where p

(c

B

|a

k

)

is the probability distribution of Bob’s signal conditional on sig-

nal a

k

and p

(c

B

|ˆ a

r

0)

is the probability distribution of Bob’s signal conditional

on the ﬁctitious signal ˆ a

r

0. The second equality comes from Bayes rule and

the conditional independence of signals. D(p||q) ≥ 0. The equality holds only

when distributions p and q are the same. We thus have U

I

A

− U

II

A

≥ 0. When

Pr(Y |a

k

), Pr(N|a

k

) = r

0

, p

(c

B

|a

k

)

is different from p

(c

B

|ˆ a

r

0)

and hence

U

I

A

−U

II

A

is strictly greater than 0.

Since the market only has two exclusive outcomes, cases 2 and 3 are symmet-

ric. We only need to prove one of them. Without loss of generality, consider case

2 where x

n

A

< r

0

Y

≤ 1, Alice’s expected proﬁt conditioned on her signal for the

Bob-Alice subgame becomes

¯

U

II

A

=

1

Pr(c

A

= a

k

)

¸

l,z

Pr(a

k

, b

l

, z) log

Pr(ω = z|c

A

= a

k

, c

B

= b

l

)

Pr(ω = z|c

A

= a

n

A

, c

B

= b

l

)

, (7)

while U

I

A

remains the same as in (3). We obtain

U

I

A

−

¯

U

II

A

=

1

Pr(a

k

)

¸

l,z

Pr(a

k

, b

l

, z) log

Pr(z|a

k

)

Pr(z|a

n

A

)

+

¸

z

Pr(z|a

k

) log

Pr(z|a

n

A

)

r

0

z

−

¯

U

II

A

= D

p

(c

B

|a

k

)

||p

(c

B

|a

n

A

)

+

¸

z

Pr(z|a

k

) log

Pr(z|a

n

A

)

r

0

z

.

The second term in the above expression is positive because r

0

Y

> Pr(Y |a

n

A

) ≥

Pr(Y |a

k

). Hence, U

I

A

−

¯

U

II

A

> 0. Alice does not want to deviate from selecting

herself as the ﬁrst player.

Corollary 1 in Section 4 indicates that if myopic players follow predeﬁned

sequence of play then on expectation a player is better off by playing ﬁrst than

second in CI games. Theorem 3 further strengthens this result and states that if a

strategic player have a choice, at a PBE the player will always choose to play ﬁrst

in CI games no matter what signal it gets.

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 21

5.2 Sequence Selection Equilibrium of I games

In this part, we consider the alternative model in which players have independent

signals. The following theorem gives a PBE of the sequence selection game when

the I condition is satisﬁed.

Theorem 4 If the market starts with the prior probabilities for the two outcomes,

i.e. r

0

= Pr(ω = Y ), Pr(ω = N), and Alice and Bob have independent signals,

at a PBE of the sequence selection game

– Alice in the ﬁrst stage selects Bob to be the ﬁrst player;

– Bob changes the market probability to Pr(Y |c

B

), Pr(N|c

B

) in the second

stage;

– Alice changes the market probability to Pr(Y |c

A

, c

B

), Pr(N|c

A

, c

B

) in the

third stage.

Proof If Alice always selects Bob as the ﬁrst player, this action does not reveal

any information to Bob. Knowing Alice’s strategy, according to Lemma 2, Bob’s

best responds in the second stage is to truthfully report the posterior probability

conditioned on his own signal and Alice will report truthfully conditioned on both

signals in the third stage. Thus, we need to prove that Alice does not want to deviate

from selecting herself as the ﬁrst player. Without loss of generality, assume Alice

has signal a

k

.

If Alice selects herself as the ﬁrst player, her best response in the second stage

is to report truthfully. Hence, the expected proﬁt conditioned on her signal in this

case, denoted as U

I

A

, is

U

I

A

=

¸

z

Pr(ω = z|c

a

= a

k

) log

Pr(ω = z|c

a

= a

k

)

Pr(ω = z)

= D(p

(ω|a

k

)

||p

(ω)

) (8)

If Alice selects Bob as the ﬁrst player, her expected proﬁt conditioned on her sig-

nal, denoted as U

II

A

is

U

II

A

=

¸

l,z

Pr(c

b

= b

l

|a

k

) Pr(ω = z|a

k

, b

l

) log

Pr(ω = z|a

k

, b

l

)

Pr(ω = z|b

l

)

=

¸

l

Pr(c

b

= b

l

|a

k

)D(p

(ω|a

k

,b

l

)

||p

(ω|b

l

)

) (9)

Because signals are independent, we have Pr(b

l

|a

k

) = Pr(b

l

). Hence,

Pr(z|a

k

) =

¸

l

Pr(b

l

|a

k

) Pr(z|a

k

, b

l

) =

¸

l

Pr(b

l

) Pr(z|a

k

, b

l

). By Bayes rule,

Pr(z) =

¸

l

Pr(b

l

) Pr(z|b

l

). The difference in expected proﬁts for Alice is:

U

I

A

−U

II

A

= D(p

(ω|a

k

)

||p

(ω)

) −

¸

l

Pr(b

l

)D(p

(ω|a

k

,b

l

)

||p

(ω|b

l

)

)

= D(

¸

l

Pr(b

l

)p

(ω|a

k

,b

l

)

||

¸

l

Pr(b

l

)p

(ω|b

l

)

) −

¸

l

Pr(b

l

)D(p

(ω|a

k

,b

l

)

||p

(ω|b

l

)

)

≤ 0.

22 Y. Chen et al.

The inequality follows from the convexity of relative entropy [11]. Thus, Alice

does not want to deviate from selecting Bob as the ﬁrst player.

The strategies and beliefs off the equilibrium path are straightforward. If Alice

selects herself to be the ﬁrst players. In the second stage, her best response is to

report her true posterior. Bob believes that Alice reports truthfully.

Corollary 2 in Section 4 indicates that if myopic players follow predeﬁned se-

quence of play then on expectation a player is better off by playing second than

ﬁrst in I games. Theorem 4 further strengthens this result and states that if a strate-

gic player have a choice, at a PBE the player will always choose to play second in

I games no matter what signal it gets.

6 The Alice-Bob-Alice Game

We now consider a 3-stage Alice-Bob-Alice game, where Alice plays in the ﬁrst

and third stages and Bob plays in the second stage. Alice may change the market

probabilities however she wants in the ﬁrst stage. Observing Alice’s action, Bob

may change the probabilities in the second stage. Alice can take another action in

the third stage. Then, the market closes and the true state is revealed.

Let r

t

= r

t

Y

, r

t

N

be the market probabilities in stage t. Lemma 5 character-

izes the equilibrium strategy of Alice in the third stage.

Lemma 5 In a 3-stage Alice-Bob-Alice game in LMSR, at a WPBE Alice changes

the market probabilities to r

3

= r

3

Y

, r

3

N

= Pr(Y |a

k

, b

l

), Pr(N|a

k

, b

l

in the

third stage, when Alice has signal a

k

and Bob has signal b

l

.

Proof This is proved by applying Lemma 2 to both Bob and Alice. At a WPBE,

beliefs are consistent with strategies. Alice and Bob act as if they knoweach other’s

strategy. Since Bob only gets one chance to play, according to Lemma 2 Bob plays

truthfully and fully reveals his information. Because the third stage is Alice’s last

chance to change the probabilities, Alice behaves truthfully and fully reveals her

information, including her own signal and Bob’s signal inferred from Bob’s action

in the second stage.

6.1 Truthful Equilibrium of CI Games

We study the PBE of the game when Alice and Bob have conditionally independent

signals. Built on our equilibrium result for the sequence selection game, Theorem

5 describes a PBE of the Alice-Bob-Alice game.

Theorem 5 When Alice and Bob have conditionally independent signals in LMSR,

at a PBE of the 3-stage Alice-Bob-Alice game

– Alice changes the market probability to r

1

= Pr(Y |c

A

), Pr(N|c

A

) in the

ﬁrst stage;

– Bob in the second stage changes the market probability to r

2

=

Pr(Y |c

A

, c

B

), Pr(N|c

A

, c

B

);

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 23

– Alice does nothing in the third stage.

Proof Bob’s belief µ

B

is similar to that of the sequence selection game as de-

scribed in the proof for Theorem 3. We denote x = x

1

, ..., x

n

A

as the vector

of Alice’s possible posteriors for the outcome Y . That is, x

i

= Pr(Y |c

A

= a

i

),

where a

i

is the i-th element of C

A

. Without loss of generality, assume that x

i

< x

j

iff i < j. When Alice changes market probability to r

1

in the ﬁrst stage, Bob’s

belief µ

B

gives

– If x

1

≤ r

1

Y

≤ x

n

A

, Pr(Y |r

1

, µ

B

) = r

1

Y

.

– If 0 ≤ r

1

Y

< x

1

, Pr(Y |r

1

, µ

B

) = x

1

.

– If x

n

A

< r

1

Y

≤ 1, Pr(Y |r

1

, µ

B

) = x

n

A

.

When observing a r

1

Y

= y = x

i

for all 1 ≤ i ≤ n

A

, Bob’s belief µ

B

is consistent

with Alice’s off-equlibrium mixed strategy:

– If c

A

= a

i

or c

A

= a

i+1

and x

i

< y < x

i+1

, mix between truthful betting

and reporting r

1

Y

= y. When c

A

= a

i

, with probability α change market

probability to r

1

Y

= y and (1−α) play truthful betting. When c

A

= a

i+1

, with

probability β change market probability to r

1

Y

= y and (1 − β) play truthful

betting. The mixing probabilities α and β satisfy that Pr(Y |r

1

Y

= y) = y.

– If c

A

= a

1

and 0 ≤ y < x

1

, change market probability to r

1

Y

= y.

– If c

A

= a

n

A

and x

n

A

< y ≤ 1, change market probability to r

1

Y

= y.

– For all other cases, report truthfully.

By Lemma 2, Bob does not want to deviate from truthful betting in the second

stage given that Alice truthfully reports her posteriors in the ﬁrst stage.

We show that Alice does not want to deviate by changing market probabilities

to r

1

= Pr(Y |c

A

), Pr(N|c

A

). Without loss of generality, assume that Alice has

signal c

A

= a

k

. Consider the two cases:

1. When Alice does not deviate: Alice changes market probabilities to her true

posteriors Pr(Y |a

k

), Pr(N|a

k

) in the ﬁrst stage; Bob changes the probabil-

ities to Pr(Y |a

k

, c

B

), Pr(N|a

k

, c

B

) in the second stage; Alice does nothing

in the third stage.

2. When Alice deviates: Alice changes market probabilities to r

1

that is dif-

ferent from Pr(Y |a

k

), Pr(N|a

k

); Bob changes market probabilities to

Pr(Y |r

1

, c

B

, µ

B

), Pr(N|r

1

, c

B

, µ

B

) in the second stage, and Alice plays

a best response according to Lemma 5 by changing market probabilities to

Pr(Y |a

k

, c

B

), Pr(N|a

k

, c

B

) in the third stage.

We compare Alice’s expected proﬁts conditional on her signal in these two

cases with the aid of the sequence selection game. The total payoff of two consec-

utive moves, in a market using the LMSR, is exactly the payoff of moving from the

starting point to the end point of the second move. Hence, the expected proﬁt that

Alice gets from case 1 is the same as what she gets from the following sequence

of actions: (a) Alice changes market probabilities to r

1

that are different from her

posteriors in the ﬁrst stage; (b) A sequence selection game starts with initial mar-

ket probabilities r

1

; Alice selects herself to be the ﬁrst player; (c) Alice changes

24 Y. Chen et al.

market probabilities to Pr(Y |a

k

), Pr(N|a

k

); (d) Bob changes market probabili-

ties to Pr(Y |a

k

, c

B

), Pr(N|a

k

, c

B

). Similarly, the expected proﬁt that Alice gets

from case 2 is the same as what she gets from the following sequence of actions:

(a’) Alice changes market probabilities to r

1

that are different from her poste-

riors in the ﬁrst stage; (b’) A sequence selection game starts with initial market

probabilities r

1

; Alice selects Bob to be the ﬁrst player; (c’)Bob changes market

probabilities to Pr(Y |r

1

, c

B

, µ

B

), Pr(N|r

1

, c

B

, µ

B

); (d’) Alice changes mar-

ket probabilities to Pr(Y |a

k

, c

B

), Pr(N|a

k

, c

B

). Alice’s expected proﬁt from

(a) is the same as that from (a’). But according to Theorem 3, Alice’s expected

proﬁt from (b), (c), and (d) is greater than or equal to that from (b’), (c’), and (d’).

Hence, Alice does not want to deviate from truthful betting.

A natural question to ask, after we know that Alice being truthful is a PBE, is

whether there are other equilibria with Alice blufﬁng in the ﬁrst stage. Theorem 6

says that there are not when players have informative and distinct signals.

Theorem 6 When Alice and Bob have conditionally independent signals that are

informative and distinct, the truthful betting PBE is the unique WPBE of the 3-

stage Alice-Bob-Alice game.

Proof According to Lemma 5, at a WPBE the market probability in the third stage

always reveals information of both Alice and Bob. Thus, the total expected proﬁt

of Alice and Bob from the game is

π

AB

=

¸

k,l,z

Pr(c

A

= a

k

, c

B

= b

l

, ω = z) log

Pr(ω = z|c

A

= a

k

, c

B

= b

l

)

r

0

z

,

which is ﬁxed given r

0

and the joint probability distribution P. Let σ be Al-

ice’s strategy at a WPBE. Then, Alice’s expected proﬁt by following σ is π

A

σ

=

π

AB

− π

B

(σ), where π

B

(σ) is Bob’s expected myopic optimal proﬁt follow-

ing a ﬁrst round strategy σ as deﬁned in Section 4. According to Theorem 1,

π

B

(σ) ≥ π

B

(σ

T

) and the equality holds only when σ = σ

T

. Thus, for any WPBE

strategy σ of Alice, at the equilibrium π

A

σ

≤ π

AB

−π

B

(σ

T

), with equality holds

only when σ = σ

T

. However, any strategy σ such that π

A

σ

< π

AB

−π

B

(σ

T

) can

not be a WPBE strategy, because Alice can simply deviate to the truthful strategy

and get higher expected proﬁt. Hence, truthful betting is the only WPBE of the

game.

6.2 Nonexistence of Truthful Equilibrium in I Games

We study the equilibrium of the game when Alice and Bob have independent sig-

nals and the general informativeness condition holds. In particular, we show that

the truthful strategy in this setting is not a WPBE. Alice has an incentive to deviate

from the truthful strategy on her ﬁrst trade in the market.

The truthful strategy for Alice is the same as that in Section 6.1: change market

probability to r

1

= Pr(Y |c

A

= a

k

), Pr(N|c

A

= a

k

) in the ﬁrst stage. We deﬁne

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 25

the blufﬁng strategy for Alice as: change market probability to ˜r

1

= Pr(Y |c

A

=

˜ a

k

), Pr(N|c

A

= ˜ a

k

), where ˜ a

k

= a

k

is another signal in C

A

.

Since the total payoff of two consecutive moves in LMSR is exactly the payoff

of moving from the starting point to the end point of the second move, we may

now consider a blufﬁng strategy by Alice during the ﬁrst trade as a move from

r

0

to r

1

immediately followed by a move from r

1

to ˜r

1

. Due to the overlap in

the expected score in the truthful strategy and the blufﬁng strategy for Alice, we

eliminate the r

0

to r

1

move in our comparison analysis and treat the myopic move

as if it had zero expected proﬁt and analyze the blufﬁng strategy as a move from

r

1

to ˜r

1

.

Lemma 6 Assume that Bob expects Alice to play truthfully, and reacts accord-

ingly. If Alice observes her signal, c

A

= a

k

, and bluffs, her expected change in

proﬁt over following the truthful strategy, is

∆ =

¸

l

Pr(c

B

= b

l

|c

A

= a

k

)D(p

(ω|a

k

,b

l

)

||p

(ω|˜ a

k

,b

l

)

) −D(p

(ω|a

k

)

||p

(ω|˜ a

k

)

),

where p

(ω|·)

denotes the probability distribution of ω conditional on signal real-

izations.

Proof For conciseness, we use Pr(a

k

) to represent Pr(c

A

= a

k

) and similarly for

other terms. Alice’s ﬁrst trade is a move from r

1

to ˜r

1

, by the deﬁnition of LMSR

her expected score from the ﬁrst move is:

Pr(Y |a

k

) log

Pr(Y |˜ a

k

)

Pr(Y |a

k

)

+ Pr(N|a

k

) log

Pr(N|˜ a

k

)

Pr(N|a

k

)

= −D(p

(ω|a

k

)

||p

(ω|˜ a

k

)

).

As Bob has a probability of Pr(b

l

|a

k

) of seeing b

l

as his signal, Alice

will move the market from r

2

= Pr(Y |˜ a

k

, b

l

), Pr(N|˜ a

k

, b

l

) to r

3

=

Pr(Y |a

k

, b

l

), Pr(N|a

k

, b

l

) with probability Pr(b

l

|a

k

). Therefore, the expected

score of Alice’s second trade in the market is:

X

l

Pr(b

l

|a

k

)

»

Pr(Y |a

k

, b

l

) log

Pr(Y |a

k

, b

l

)

Pr(Y |˜ a

k

, b

l

)

+ Pr(N|a

k

, b

l

)

Pr(N|a

k

, b

l

)

Pr(N|˜ a

k

, b

l

)

–

=

X

l

Pr(b

l

|a

k

)D(p

(ω|a

k

,b

l

)

||p

(ω|˜ a

k

,b

l

)

)

Thus, Alice’s total expected payoff conditional on her signal is the sum of the

above two expressions, which gives ∆ in our theorem.

Theorem 7 If players have independent signals that satisfy the general informa-

tiveness condition, truthful betting is not a WPBE for the Alice-Bob-Alice game.

Proof Lemma 6 gives the expected proﬁt change of Alice if she were to deviate

from truthful betting. Below we show that the expected proﬁt change of deviating

from the truthful strategy is greater than zero, thus Alice has an incentive to deviate

from the truthful strategy. We have

¸

l

Pr(b

l

|a

k

)D(p

(ω|a

k

,b

l

)

||p

(ω|˜ a

k

,b

l

)

)

≥ D(

¸

l

Pr(b

l

|a

k

)p

(ω|a

k

,b

l

)

||

¸

l

Pr(b

l

|a

k

)p

(ω|˜ a

k

,b

l

)

)

= D(p

(ω|a

k

)

||p

(ω|˜ a

k

)

)

26 Y. Chen et al.

The inequality follows from the convexity of relative entropy [11]. We note that by

the general informativeness condition the inequality is strict. The equality follows

from the independence of the two signals, Pr(b

l

|a

k

) = Pr(b

l

), and the law of total

probability. Therefore, ∆ > 0. Truthful betting is not a WPBE strategy.

6.2.1 Explicit Blufﬁng Equilibria in a Restricted Game We now introduce a sim-

ple model of independent signals and show that blufﬁng can be an equilibrium.

In our model, Alice and Bob each see an independent coin ﬂip and then partici-

pate in a LMSR prediction market with outcomes corresponding to whether or not

both coins came up heads. Thus, ω ∈ {HH, (HT|TH|TT)}. We again consider an

Alice-Bob-Alice game structure.

Theorem 8 Consider the Alice-Bob-Alice LMSR coin-ﬂipping game, where the

probability of heads is p. Now restrict Alice’s ﬁrst stage strategies to either play

truthful betting (TB) or as if her coin is heads (

ˆ

H). A WPBE in this game has Alice

play TB with probability t = 1 +

p

(1−(1−p)

−1/p

)(1−p)

, and otherwise play

ˆ

H.

Proof To show that playing TB with probability t is an equilibrium, we ﬁrst com-

pute Bob’s best response to such a strategy and then show that Bob’s strategy

makes Alice indifferent between her pure strategies. Bob’s best response is, if he

has heads, to set the probability of HH to the probability that Alice has heads given

that she bets as if she does (we denote Alice betting as if she had heads as

ˆ

H):

Pr(HH |

ˆ

HH) =

Pr(

ˆ

HH | HH) Pr(HH)

Pr(

ˆ

HH | HH) Pr(HH) + Pr(

ˆ

HH | TH) Pr(TH)

=

1 · p

2

1 · p

2

+ (1 −t)(1 −p)p

= 1 −(1 −p)

1

p

.

(10)

If Bob has tails he sets the probability of HH to zero. Assuming such a strategy

for Bob, we can compute Alice’s expected proﬁt for playing TB. This is done

by computing, for each outcome in {HH,HT,TH,TT}, her proﬁt for moving the

probability from p

0

to p or 0, plus her proﬁt for moving the probability to 0 or 1

from where Bob moves it. We have

p

2

log

p

p

0

+ log

1

x

+p(1 −p) log

1−p

1−p

0

+ (1 −p)p log

1−0

1−p

0

+ (1 −p)

2

log

1−0

1−p

0

(11)

where x is Bob’s posterior probability when he has heads and Alice appears to

have heads. Similarly, Alice’s expected proﬁt for always pretending to have heads

in the ﬁrst stage is:

p

2

log

p

p

0

+ log

1

x

+p(1 −p) log

1−p

1−p

0

+ (1 −p)p

log

1−p

1−p

0

+ log

1−0

1−x

+ (1 −p)

2

log

1−p

1−p

0

.

(12)

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 27

Since (11) and (12) are equal when x is set according to (10), Alice is indifferent

between truthfulness and blufﬁng when Bob expects her to play TB with probabil-

ity t. It is therefore in equilibrium for Alice to play TB with probability t, that is,

Alice should, with 1 − t probability, pretend to have seen heads regardless of her

actual information.

7 Finite-Player Finite-Stage Game

We extend our results for the Alice-Bob-Alice game to games with a ﬁnite number

of players and ﬁnite stages in LMSR. Each player can change the market proba-

bilities multiple times and all changes happen in sequence.

7.1 Truthful Equilibrium of CI games

We ﬁrst consider the CI setting where players have conditionally independent sig-

nals. The following theorem characterizes the PBE of the game.

Theorem 9 In the ﬁnite-player, ﬁnite-stage game with LMSR, if players have con-

ditionally independent signals, at a PBE of the game all players report their poste-

rior probabilities in their ﬁrst round of play. If signals are informative and distinct,

the truthful betting PBE is the unique WPBE of the game.

Proof Given that every player believes that all players before it act truthfully,

we prove the theorem recursively using backward induction. If it’s player i’s last

chance to play, it will truthfully report its posterior probabilities by Lemma 2. If it’s

player i’s second to last chance to play, there are other players standing in between

its second to last chance to play and its last chance to play. We can combine the

signals of those players standing in between as one signal and treat those players

as one composite player. Because signals are conditionally independent, the signal

of the composite player is conditionally independent of the signal of player i. The

game becomes an Alice-Bob-Alice game for player i and at a PBE player i reports

truthfully at its second to last chance to play according to Theorem 5. Inferring

recursively, it is a PBE at which any player reports truthfully at its ﬁrst chance to

play.

If signals are informative and distinct, Theorem 6 states that the truthful betting

PBE is the unique WPBE of the Alice-Bob-Alice game. This implies that truthful

betting PBE is also a unique WPBE for the ﬁnite-player ﬁnite-stage game. Suppose

the contrary, there is a blufﬁng WPBE. Select the last player who bluffs in the

sequence. Without loss of generality, suppose the player is Alice and she bluffs

at some stage t. Then, Alice must play truthfully at some stage t

> t + 1, and

does not play in stages between t and t

**. Combining signals of players between
**

t and t

as one composite signal. The game from stage t to stage t

becomes an

Alice-Bob-Alice game. Alice blufﬁng at stage t contradicts with the uniqueness of

the WPBE of the Alice-Bob-Alice game.

28 Y. Chen et al.

7.2 No Truthful Equilibrium in I Games

For the I setting where players have independent signals, the result for ﬁnite-player

ﬁnite-stage game directly follow from our result on the Alice-Bob-Alice game.

Theorem 10 In the ﬁnite-player, ﬁnite-stage game with LMSR, if players have

independent signals that satisfy the general informativeness condition, and there

is at least one player who trades more than once, truthful betting is not a WPBE

strategy.

Proof Consider the last two trades of a player who plays more than once, for

example Alice. If t and t

**> t + 1 are the last two stages for Alice to trade and
**

all other players play truthfully, we can combine signals of all players who trade

between t and t

**as a composite signal possessed by a composite agent. Because
**

signals are independent, Alice’s signal is independent of the composite signal. The

game from stage t to stage t

**can be viewed as an Alice-Bob-Alice game. By
**

Theorem 7, we know that Alice is better off by blufﬁng at stage t. Hence, truthful

betting is not a WPBE.

8 Finite-Player Inﬁnite-Stage Games

In this section, we analyze a model in which the number of potential moves can be

inﬁnite. This is motivated by the observation that there is often no pre-deﬁned last

stage for a player. A player may decide to have one more trade at any time before

the market closes.

We extend our results for ﬁnite-stage games to inﬁnite-stage games and exam-

ine the equilibrium for CI and I settings respectively.

8.1 Truthful Betting Equilibrium in CI Games

Games with conditionally independent signals remain to have a unique equilib-

rium, truthful betting PBE, as is shown in the following theorem.

Theorem 11 In a potentially inﬁnite-stage game with conditionally independent

signals, at a ﬁnite PBE all players truthfully report their posterior probabilities at

their ﬁrst chance of play. If signals are informative and distinct, the truthful betting

equilibrium is the unique ﬁnite WPBE of the game.

Proof If there are mplayers, truthful betting reveals all information after mstages.

Knowing that other players are playing truthfully, a player who plays in stage

i < m does not want to deviate to blufﬁng in stage i and come to trade again in

stage m + 1, because the game between stages i and m + 1 can be viewed as an

Alice-Bob-Alice game. According to Theorem 5 player i would prefer to report

truthfully.

If there exists a ﬁnite equilibriumthat reveals all information at stage t, suppose

the last time for a player to bluff is in stage i, then it must report truthfully in some

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 29

stage j and i + 1 < j ≤ t. The game between stages i and j can be viewed

as an Alice-Bob-Alice game. If signals are informative and distinct, according to

Theorem 6, truthful betting equilibrium is the only WPBE of the Alice-Bob-Alice

game. Contradiction arises. Truthful betting is the only ﬁnite equilibrium.

8.2 Nonexistence of Finite Equilibrium in I Games

Theorem 12 In an inﬁnite-stage game with independent signals that satisfy the

general informativeness condition, there is no WPBE that reveals all information

after ﬁnite number of trades.

Proof For contradiction, consider any WPBE strategy proﬁle σ that always results

in the optimal market prediction after some number t of stages in a potentially

inﬁnite-stage game. Consider the last two players, Alice and Bob without loss of

generality. They play in stages t −1 and t respectively. Because the WPBE reveals

all information, both Alice and Bob reports truthfully at stages t − 1 and t. Then,

according to Theorem 7, Alice would want to deviate to bluff in stage t − 1 and

play again in stage t +1. Thus, σ can not be a WPBE strategy proﬁle. There is not

ﬁnite equilibrium.

Intuitively if a player has some private information that may be revealed by

its signal, it has an incentive to not fully divulge this information when it may

play multiple times in the market. The general informativeness condition guaran-

tees that no matter what the signal distribution is, a player will always have some

private information revealed by its signal.

9 Discounted LMSR and Entropy Reduction

For inﬁnite-stage games, when players have independent signals, the market can

not fully aggregate information of all players with ﬁnite trades. We propose a dis-

counted logarithmic market scoring rule and show that the I games can converge

to full information aggregation exponentially.

We ﬁrst introduce the discounted LMSR mechanism in Section 9.1. Then, we

characterize the inﬁnite-stage games as continuation games in Section 9.2 and in-

troduce the concepts of complementarity and substitution of signals in Section

9.3. We present a natural metric to quantify degree of information aggregation in

Section 9.4. Facilitated with results in Sections 9.2, 9.3, and 9.4, we present our

convergence analysis for discounted LMSR in Section 9.5.

9.1 Discounted LMSR

One way to address the incentives that traders with independent signals have to

bluff in a market using the logarithmic market scoring rule is to reduce future

payoffs using a discount parameter, perhaps resulting in an incentive to play the

truthful strategy. Based on this intuition, we propose the discounted LMSR market.

30 Y. Chen et al.

Let δ ∈ (0, 1) be a discount parameter. The δ-discounted market scoring

rule is a market microstructure in which traders update the predicted probability

of the event under consideration just as they would in the regular market scoring

rule. However, the value (positive or negative) of trade is discounted over time.

2

For simplicity, we assume a strict alternating sequence of trades between Alice

and Bob. Suppose a trader moves the prediction for outcome Y from p to q in

the i-th stage of the market, and the outcome Y is later observed to happen. The

trader would then be given a payoff of δ

i−1

(log q − log p). On the other hand, if

the outcome Y did not happen, and the trader moves the prediction from p to q in

the i-th stage the trader would earn a payoff of δ

i−1

(log(1 −q) −log(1 −p)). The

regular market scoring rule corresponds to δ = 1.

Clearly, the myopic strategic properties of the market scoring rule are retained

in the discounted form. We note that for CI games, truthful betting is still the

unique WPBE in the discounted LMSR. Intuitively, for an Alice-Bob-Alice CI

game in the discounted LMSR, Alice does not want to deviate from the truthful

betting strategy as in the non-discounted LMSR because for any deviating strat-

egy her expected proﬁt in the ﬁrst stage is the same in both the non-discounted

LMSR and the discounted LMSR but her expected proﬁt in the third stage in the

discounted LMSR is strictly less than that in the non-discounted LMSR, mak-

ing deviation even more undesirable. As truthful betting is the unique WPBE in

an Alice-Bob-Alice CI game in the discounted LMSR, the same arguments in Sec-

tions 7.1 and 8.1 can show that truthful betting is the unique WPBE for ﬁnite-stage

and inﬁnite-stage CI games with ﬁnite players in the discounted LMSR. Thus,

from now on, we only focus on I games in the discounted LMSR.

We will show that the discounted LMSR can have better non-myopic strategic

properties for I games. For simplicity, we assume that there are only two play-

ers, Alice and Bob. They alternately play in the market, with Alice being the ﬁrst

player. Even though that the discounted LMSRmay admit equilibria in which play-

ers bluff with some probability, we will show that, in any WPBE strategy proﬁle

σ, the market price will converge towards the optimal probability for the particular

realized set of information signals. In other words, although complete aggregation

of information may not happen in two rounds, it does surely happen in the long

run at any WPBE.

9.2 Continuation Games

It is useful to think about an inﬁnite-stage market game G as a ﬁrst-stage move

followed by a subsequent game H that perhaps depends on the ﬁrst-stage move.

This decomposition is possible in equilibrium analysis, because the actual ﬁrst-

stage strategy σ

1

is common knowledge in an equilibrium proﬁle. Then, the beliefs

of the players after observing the ﬁrst move x are consistent with private signals

2

It is possible that traders intrinsically discount future proﬁts; for example, they may be

uncertain about how long their information will remain private. We do not, however, assume

any intrinsic discounting by traders; rather, we are proposing a mechanism that explicitly

discounts gains and losses in later rounds.

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 31

and a common prior p

**that depends on the initial prior p
**

0

, the ﬁrst-stage strategy

σ

1

and the observed move x.

Deﬁnition 3 We say that H is a continuation game of G if there is a ﬁrst-stage

strategy σ

1

and a move x such that x is played with nonzero probability under σ,

the prior p

in H is consistent with p

0

, σ

1

, and x, and the sequence of play in H

is the same as the subsequence of play in G after the ﬁrst move in G. We denote

this G → H.

We deﬁne the relation

∗

→ as the reﬂexive transitive closure of →, i.e.,

we write G

∗

→ H and say G reduces to H if there is a sequence G =

H

0

, H

1

, H

2

, . . . , H

k

= H such that H

i

→ H

i+1

for all i. We deﬁne G

∗

→ G

to always be true.

Observe that if G

∗

→ H, then, the full-information optimal probabilities

Pr(Y |c

A

= a, c

B

= b) for any given pair of signal realizations (a, b) are the

same in G and H. Only the prior over different signals changes after a ﬁrst-round

strategy, not the full-information posterior probabilities.

Lemma 7 shows that continuation games preserve the independence property

of the original game.

Lemma 7 Suppose G

∗

→ H. Then,

– If G satisﬁes the conditional independence (CI) property, so does H.

– If G satisﬁes the independence (I) property, so does H.

Proof We need to show that if H

i

→ H

i+1

, H

i+1

satisﬁes the same independence

property as H

i

.

Let σ be a WPBE strategy for game H

i

. Without loss of generality, suppose

that x is one of the points that the ﬁrst player in H

i

plays with positive probability

according to σ. Let P

i

be the joint probability distribution for H

i

. We use P

i

{·}

to represent probability of some outcome under P

i

. Let P

i

{c

1

= k|x, σ} be the

probability that player 1 has signal k conditional on that it plays x. Then, knowing

player 1 follows σ, player 2 updates its beliefs after seeing x, the continuation

game H

i+1

has joint probability distribution P

i+1

such that

P

i+1

{c

1

= k, c

2

= l, ω = z} = P

i

{c

1

= k, c

2

= l, ω = z|x, σ}

= P

i

{c

1

= k|x, σ}P

i

{c

2

= l, ω = z|c

1

= k}

=

P

i

{c

1

= k|x, σ}

P

i

{c

1

= k|σ}

P

i

{c

1

= k, c

2

= l, ω = z}

where k, l, and z represent signal realization of player 1, signal realization of

player 2, and realized outcome respectively.

32 Y. Chen et al.

We ﬁrst show that if P

i

of game H

i

satisﬁes CI condition, P

i+1

of game H

i+1

also satisﬁes CI condition.

P

i+1

{c

1

= k, c

2

= l|ω = z} =

P

i+1

{c

1

= k, c

2

= l, ω = z}

P

i+1

{ω = z}

=

P

i

{c

1

=k|x,σ}

P

i

{c

1

=k|σ}

P

i

{c

1

= k, c

2

= l, ω = z}

P

i+1

{ω = z}

=

P

i

{c

1

=k|x,σ}

P

i

{c

1

=k|σ}

P

i

{c

1

= k, c

2

= l|ω = z}

P

i+1

{ω = z}/P

i

{ω = z}

=

P

i

{c

1

=k|x,σ}

P

i

{c

1

=k|σ}

P

i

{c

1

= k|ω = z}P

i

{c

2

= l|ω = z}

P

i+1

{ω = z}/P

i

{ω = z}

.

P

i+1

{c

1

= k|ω = z} =

P

i

{c

1

=k|x,σ}

P

i

{c

1

=k|σ}

P

i

{c

1

= k, ω = z}

P

i+1

{ω = z}

=

P

i

{c

1

=k|x,σ}

P

i

{c

1

=k|σ}

P

i

{c

1

= k|ω = z}

P

i+1

{ω = z}/P

i

{ω = z}

.

P

i+1

{c

2

= l|ω = z} =

¸

k

P

i

{c

1

=k|x,σ}

P

i

{c

1

=k|σ}

P

i

{c

1

= k, c

2

= l, ω = z}

P

i+1

{ω = z}

=

¸

k

P

i

{c

1

=k|x,σ}

P

i

{c

1

=k|σ}

P

i

{c

1

= k, c

2

= l|ω = z}

P

i+1

{ω = z}/P

i

{ω = z}

=

¸

k

P

i

{c

1

=k|x,σ}

P

i

{c

1

=k|σ}

P

i

{c

1

= k, c

2

= l|ω = z}

¸

k

P

i

{c

1

=k|x,σ}

P

i

{c

1

=k|σ}

P

i

{c

1

= k, ω = z}/P

i

{ω = z}

= P

i

{c

2

= l|ω = z}.

Thus, we also have

P

i+1

{c

1

= k, c

2

= l|ω = z} = P

i+1

{c

1

= k|ω = z}P

i+1

{c

2

= l|ω = z}.

CI condition holds for H

i+1

.

We then show that if P

i

of game H

i

satisﬁes I condition, P

i+1

of game H

i+1

also satisﬁes I condition.

P

i+1

{c

1

= k, c

2

= l} =

¸

ω

P

i+1

{c

1

= k, c

2

= l, ω = z}

=

¸

ω

P

i

{c

1

= k|x, σ}

P

i

{c

1

= k|σ}

P

i

{c

1

= k, c

2

= l, ω = z}

=

P

i

{c

1

= k|x, σ}

P

i

{c

1

= k|σ}

P

i

{c

1

= k, c

2

= l}

=

P

i

{c

1

= k|x, σ}

P

i

{c

1

= k|σ}

P

i

{c

1

= k|σ}P

i

{c

2

= l}

= P

i

{c

1

= k|x, σ}P

i

{c

2

= l}

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 33

The second to the last equality is because of the independence condition of H

i

. We

also have

P

i+1

{c

1

= k} =

¸

l

P

i+1

{c

1

= k, c

2

= l}

=

¸

l

P

i

{c

1

= k|x, σ}

P

i

{c

1

= k|σ}

P

i

{c

1

= k, c

2

= l}

=

¸

l

P

i

{c

1

= k|x, σ}

P

i

{c

1

= k|σ}

P

i

{c

1

= k|σ}P

i

{c

2

= l}

= P

i

{c

1

= k|x, σ}

and

P

i+1

{c

2

= l} =

¸

k

P

i+1

{c

1

= k, c

2

= l}

=

¸

k

P

i

{c

1

= k|x, σ}

P

i

{c

1

= k|σ}

P

i

{c

1

= k, c

2

= l}

=

¸

k

P

i

{c

1

= k|x, σ}

P

i

{c

1

= k|σ}

P

i

{c

1

= k|σ}P

i

{c

2

= l}

= P

i

{c

2

= l}.

Hence, P

i+1

{c

1

= k, c

2

= l} = P

i+1

{c

1

= k}P

i+1

{c

2

= l}. H

i+1

satisﬁes

independence.

By induction, if G

∗

→ H, then H preserves the same independence property as

G.

9.3 Complementarity or Substitution of Signals

In this section, we introduce the concept of complementarity for signals. Intu-

itively, if signals of Alice and Bob are complements, the expected proﬁt from

knowing both signals is greater than the sum of the expected proﬁts from knowing

only the individual signals. If signals are substitutes, the relation is reversed.

For a game G participated by Alice and Bob, the total proﬁt potential in G is

π

AB

= π

A

(σ

N

) +π

B

(σ

T

). In other words, π

AB

is the sum of Alice’s and Bob’s

expected proﬁt if they both follow the truthful strategy, and Alice moves ﬁrst. We

note that under either the CI condition or the I condition, the order of play is not

important, i.e., π

AB

= π

B

(σ

N

) +π

A

(σ

T

) = H(ω|c

A

, c

B

).

Now we deﬁne the complementarity coefﬁcient of a game that captures the

complementarity of players’ signals.

Deﬁnition 4 The complementarity coefﬁcient C(G) of a market game G is de-

ﬁned as

C(G) =

π

A

(σ

N

) +π

B

(σ

N

)

π

AB

,

34 Y. Chen et al.

where the right-hand side proﬁts are implicitly a function of the game G under

consideration.

The complementarity bound

ˆ

C

σ

(G) is the minimum value of C(H) over all

games H that G could reduce to by following the strategy proﬁle σ:

ˆ

C

σ

(G) = min

H:G

∗

→H by σ

C(H)

We note that if C(G) < 1, signals are complements. If C(G) > 1, signals are

substitutes.

Lemma 8 Under the CI model, any game G with informative and distinct signals

satisﬁes

ˆ

C

σ

(G) > 1 for any strategy proﬁle σ.

Proof From Theorem 1, it follows that π

B

(σ

N

) > π

B

(σ

T

) for any CI game G

with informative and distinct signals. Thus,

π

A

(σ

N

) +π

B

(σ

N

) > π

A

(σ

N

) +π

B

(σ

T

) = π

AB

⇒ C(G) > 1.

By lemma 7, we know that any H such that G

∗

→ H itself satisﬁes the CI condition

no matter what strategy the reduction follows. Thus, we must have

ˆ

C

σ

(G) > 1 for

any σ.

Lemma 9 Under the I model, any game G that starts with the prior probability

satisﬁes C(G) < 1, and thus,

ˆ

C

σ

(G) < 1.

Proof From Theorem 2, it follows that π

B

(σ

T

) > π

B

(σ

N

) for any I game G

starting with the prior probability. Thus,

π

A

(σ

N

) +π

B

(σ

N

) < π

A

(σ

N

) +π

B

(σ

T

) = π

AB

⇒ C(G) < 1.

By deﬁnition of

ˆ

C, we have

ˆ

C

σ

(G) ≤ C(G), and thus we must have

ˆ

C

σ

(G) < 1.

**9.4 Proﬁt Potential and Entropy
**

We now present a natural metric, the information deﬁcit D

i

, that quantiﬁes the

degree of aggregation in a prediction market after i trades under strategy proﬁle σ:

D

i

is the expectation, over all possible signal realizations and the randomization

of moves as dictated by σ, of the relative entropy between the optimal probability

(given the realization of the signals) and the actual probability after i stages.

Formally, for a strategy proﬁle σ and a number of stages t, an information

node φ consists of a realization of the signals of the two players and a sequence

of t trades in the market. Let p

i

(φ) = Pr(Y |ﬁrst i trades in φ, σ), and denote

p

i

(φ) = p

i

(φ), 1 − p

i

(φ). Let p

∗

(φ) = Pr(Y |realization of signals in φ), and

denote p

∗

(φ) = p

∗

(φ), 1 − p

∗

(φ). The aggregative effect of the strategy pro-

ﬁle σ after i trades is summarized by the collection of information nodes φ that

can be reached, the market probability p

i

(φ) in stage i, and the associated ex-ante

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 35

probability Pr(φ) of reaching each such information node. Now for i ≤ t, we

deﬁne

D

i

(σ) = E

σ

[D(p

∗

(φ)||p

i

(φ))]

=

¸

φ:φ∈σ

Pr(φ)D(p

∗

(φ)||p

i

(φ)) .

When t = 0, the information nodes φ correspond to different realizations of the

signals. Note that D

0

is the same as π

AB

deﬁned in the previous section.

If D

i

= 0, it implies that the market will always have reached its optimal

probability for the realized signals by the i-th stages. If D

i

> 0, it indicates that,

with positive probability, the market has not yet reached the optimal probability.

D

i

is always nonnegative, because the relative entropy is always nonnegative.

We now show that, in addition to measuring the distance from full information

aggregation, D

i

also enables interesting strategic analysis. The key result is that D

i

can be related to the expected payoff of the i-th stage move in the non-discounted

(standard) LMSR:

Lemma 10 Let M

i

denote the expected proﬁt (over all signal nodes φ

i

) of the i-th

trade under proﬁle σ. Then, M

i

= D

i−1

−D

i

Proof

M

i

=

¸

φ:φ∈σ

Pr(φ)

¸

p

∗

(φ) log

p

i

(φ)

p

i−1

(φ)

+ (1 −p

∗

(φ)) log

1 −p

i

(φ)

1 −p

i−1

(φ)

=

¸

φ:φ∈σ

Pr(φ)

D(p

∗

||p

i−1

) −D(p

∗

||p

i

)

= D

i−1

−D

i

The ﬁrst equality holds by the deﬁnition of M

i

and the second by the deﬁnition of

relative entropy.

This suggests another interpretation for D

i

: D

i

represents the expected value

of the potential proﬁt left for trades after the i-th trade.

Given the deﬁnition of M

i

, we can now deﬁne

˜

M

i

as the expected proﬁt of the

i-th trade in the discounted LMSR. We assume discounting after every even trade,

i.e., after every trade by Bob.

˜

M

i

=

δ

k

(D

2k

−D

2k+1

) ∀i = 2k + 1

δ

k

(D

2k+1

−D

2(k+1)

) ∀i = 2k + 2

(13)

Using the deﬁnition of

˜

M

i

we write the total proﬁt for Alice in the δ-

discounted LMSR as:

Alice’s payoff =

¸

i:i=2k,k∈Z

+

˜

M

i−1

= D

0

−D

1

+δ(D

2

−D

3

) +. . .

We can similarly rewrite Bob’s expected payoff as:

Bob’s payoff =

¸

i:i=2k,k∈Z

+

˜

M

i

= D

1

−D

2

+δ(D

3

−D

4

) +. . .

36 Y. Chen et al.

We reiterate that the deﬁnition of D

i

is not dependent on δ. It is a measure

of the informational distance between the prices after i trades in proﬁle σ and the

optimal prices. Of course, the stability of a given strategy proﬁle σ may change

with δ.

9.5 Asymptotic Convergence in Discounted LMSR for I Games

In this part, we bound the value of D

n

for large n, in any WPBE, for I games

that start with the prior probability. We will express our convergence bound in

terms of complementarity coefﬁcient, C(G). Note that if C(G) = 0, the myopic

strategy may not involve any movement by either player, and thus, we could have

lack of information aggregation even with the myopic strategy. We exclude such

degenerate cases, and assume that C(G) > 0.

Now, ﬁx a discount parameter δ, and a particular instance of the two-person

market game induced by the δ-discounted LMSR. Let σ be any WPBE of this

market game. Without loss of generality we assume that Bob moves second in the

market.

In the ﬁrst stage, Alice will take some (perhaps mixed) action x dictated by

σ. Under the equilibrium strategy proﬁle σ, Bob will revise his beliefs consistent

with the proﬁle σ and the realized action x. According to Theorem 2, we have

π

B

(σ) ≥ π

B

(σ

N

).

Recall that after stage 2, the total expected payoff of both players is at most

δD

2

. We also know that the total expected payoff of Alice in equilibrium is at

least π

A

(σ

N

), because if not, a simple deviation to the truthful strategy would

be beneﬁcial. Because π

B

(σ) ≥ π

B

(σ

N

), the total expected payoff of Bob in

equilibrium is also at least π

B

(σ

N

). This means that the total payoff of the ﬁrst

two rounds in the market is at least π

A

(σ

N

) +π

B

(σ

N

) −δD

2

. Therefore we can

bound D

2

as:

D

2

≤ D

0

−[π

A

(σ

N

) +π

B

(σ

N

) −δD

2

].

Note that D

0

= π

AB

.

This argument generalizes to any even number of rounds, by looking at the

total expected proﬁts within the ﬁrst 2k moves, and the remaining proﬁt potential

δ

k

D

2k

:

D

2k

≤ D

0

−[π

A

(σ

N

) +π

B

(σ

N

) −δ

k

D

2k

] (14)

⇐⇒ (1 −δ

k

)D

2k

≤ D

0

−[π

A

(σ

N

) +π

B

(σ

N

)]

= D

0

1 −

π

A

(σ

N

) +π

B

(σ

N

)

D

0

⇐⇒ D

2k

≤

D

0

(1 −C(G))

1 −δ

k

(15)

Note that, by deﬁnition, C(G) ≥

ˆ

C

σ

(G). Thus, we can rewrite inequality (15)

as:

D

2k

≤

D

0

(1 −

ˆ

C

σ

(G))

1 −δ

k

(16)

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 37

From inequality (16) we see that the bound on D

2k

depends only on δ, as

D

0

and

ˆ

C

σ

(G) are both constants for any instance of the market and equilibrium

proﬁle σ. Now consider the remainder of the game after 2k rounds, denoted as

H

2k

, then G

∗

→ H

2k

. According to Lemma 7, H

2k

preserves the independence

property of G. Hence, the equilibrium proﬁle σ will also induce an equilibrium

proﬁle on H

2k

. We can repeat the argument to bound D

4k

in terms of D

2k

, etc.

In this way, we rewrite inequality (16) in terms of δ and for a round n = 2km.

We set k such that δ

k/2

=

ˆ

C

σ

(G), i.e. k =

2 log

ˆ

C

σ

(G)

log δ

. Using this value of k and a

value m =

n

2k

we note that:

D

n

≤ D

0

1−

ˆ

C

σ

(G)

1−δ

k

m

= D

0

1−

ˆ

C

σ

(G)

(1−δ

k/2

)(1+δ

k/2

)

m

= D

0

(1 +δ

k/2

)

−m

= D

0

(1 +

ˆ

C

σ

(G))

−

n

2k

= D

0

(1 +

ˆ

C

σ

(G))

−

nlog δ

4 log

ˆ

C

σ

(G)

= D

0

δ

n

−log(1+

ˆ

C

σ

(G))

4 log

ˆ

C

σ

(G)

(17)

Note that

−log(1+

ˆ

C

σ

(G))

4 log

ˆ

C

σ

(G)

depends only on the complementarity bound of

the game. According to Lemma 9, for any game G with independent signal,

ˆ

C

σ

(G) < 1. Hence,

−log(1+

ˆ

C

σ

(G))

4 log

ˆ

C

σ

(G)

> 0. Therefore, inequality (17) shows that

the relative entropy of the probabilities with respect to the optimal probabilities

reduces exponentially over time.

To summarize, we have proven the following result:

Theorem 13 Let G be a market game in the I model, with a δ-discounted log-

arithmic market scoring rule. For this game, let σ be any WPBE strategy proﬁle.

Then, for all n > 1, the information deﬁcit D

n

after n rounds of trading is bounded

by

D

n

≤ D

0

δ

n

−log(1+

ˆ

C

σ

(G))

4 log

ˆ

C

σ

(G)

10 Conclusion

We have investigated the strategic behavior of traders in LMSR prediction mar-

kets using dynamic games with incomplete information. Speciﬁcally, we examine

different scenarios where traders at equilibrium bet truthfully or bluff.

Two different information structures, conditional independence and uncondi-

tional independence of signals, are considered. Both ﬁnite-stage and inﬁnite-stage

games are investigated. We show that traders with conditionally independent sig-

nals may be worse off by blufﬁng in LMSR. Moreover, for both ﬁnite-stage and

inﬁnite-stage games, truthful betting is not only a PBE strategy but also a unique

WPBE strategy for all traders in LMSR.

38 Y. Chen et al.

On the other hand, when the signals of traders are unconditionally independent,

truthful betting is not a WPBE for ﬁnite-stage games. Traders have incentives to

strategically mislead other traders with the intent of correcting the errors made

by others in a later stage. We provide a blufﬁng equilibrium for a restricted two-

player game. For inﬁnite-stage games with unconditionally independent signals,

there does not exist any WPBE that fully reveals information of all players in

ﬁnite stages.

We use a simple modiﬁcation to the market scoring rule, which includes a

form of discounting, to ameliorate this potential problem. This allows us to prove

a bound on the rate at which the error of the market, as measured by the relative

entropy between full information aggregation and the actual market probability,

reduces exponentially over time. The exponent depends on the complementarity

coefﬁcient of the market instance.

The need for discounting shows a connection to classical bargaining settings in

which players bargain over how to divide a surplus they can jointly create. In a pre-

diction market, informed players can extract a proﬁt from the market. Moreover,

players can pool their information together to make sharper predictions than either

could alone and thus extract an even larger proﬁt. They might engage in blufﬁng

strategies to bargain over how this subsidy is divided. Explicit discounting can

make this bargaining more efﬁcient.

Acknowledgments

Stanko Dimitrov was supported by NSF grants CCF-0728768 and IGERT-

0114368. Rahul Sami was partially supported by NSF grant CCF-0728768.

We are grateful to Paul J. Healy and Mohammad Mahdian for helpful discus-

sions. We thank John Ledyard for pointing us to earlier work on discounting in

parimutuel markets. We thank anonymous reviewers for their valuable comments.

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the inﬁnite-stage market with discounting, the market price converges to the fullyrevealing price, and the rate of convergence can be bounded in terms of the discounting parameter. When signals are conditionally independent, truthful betting is the unique WPBE for the inﬁnite-stage market with and without discounting. Key words Prediction markets, game theory, blufﬁng, strategic betting 1 Introduction It has long been observed that, because market prices are inﬂuenced by all the trades taking place, they reﬂect the combined information of all the traders. The strongest form of the efﬁcient markets hypothesis [14] posits that information is incorporated into prices fully and immediately, as soon as it becomes available to anyone. A prediction market is a ﬁnancial market speciﬁcally designed to take advantage of this property. For example, to forecast whether a product will launch on time, a company might ask employees to trade a security that pays $1 if and only if the product launches by the planned date. Everyone from managers to developers to administrative assistants with different forms and amounts of information can bet on the outcome. The resulting price constitutes their collective probability estimate that the launch will occur on time. Empirically, such prediction markets outperform experts, group consensus, and polls across a variety of settings [16, 17, 28, 3, 4, 18, 31, 12, 8]. Yet the double-sided auction at the heart of nearly every prediction market is not incentive compatible. Information holders do not necessarily have incentive to fully reveal all their information right away, as soon as they obtain it. The extreme case of this is captured by the so-called no trade theorems [26]: When rational, risk-neutral agents with common priors interact in an unsubsidized (zero-sum) market, the agents will not trade at all, even if they have vastly different information and posterier beliefs. The informal reason is that any offer by one trader is a signal to a potential trading partner that results in belief revision discouraging trade. The classic market microstructure model of a ﬁnancial market posits two types of traders: rational traders and noise traders [24]. The existence of noise traders turns the game among rational traders into a positive-sum game, thereby resolving the no-trade paradox. However, even in this setting, the mechanism is not incentive compatible. For example, monopolist information holders will not fully reveal their information right away: instead, they will leak their information into the market gradually over time to obtain a greater proﬁt [7]. Instead of assuming or subsidizing noise traders, a prediction market designer might choose to directly subsidize the market by employing an automated market maker that expects to lose money. Hanson’s market scoring rule market maker (MSR) is one example [20, 21]. MSR requires a patron to subsidize the market but guarantees that the patron cannot lose more than a ﬁxed amount set in advance, regardless of how many shares are exchanged or what outcome eventually occurs. The greater the subsidy, the greater the effective liquidity of the market. Since

Gaming Prediction Markets: Equilibrium Strategies with a Market Maker

3

traders face a positive-sum game, even rational risk-neutral agents have incentive to participate. In fact, even a single trader can be induced to reveal information, something impossible in a standard double auction with no market maker. Hanson proves that myopic risk-neutral traders have incentive to reveal all their information. However, forward-looking traders may not. Though subsidized market makers improve incentives for information revelation, the mechanisms are still not incentive compatible. Much of the allure of prediction markets is the promise to gather information from a distributed group quickly and accurately. However, if traders have demonstrable incentives to either hide or falsify information, the accuracy of the resulting forecast may be in question. One frequent concern about incentives in prediction markets is based on non-myopic strategies: strategies in which the attacker sacriﬁces some proﬁt early in order to mislead other traders, and then later exploit erroneous trades by other traders, thereby gaining an overall proﬁt. 1.1 Our Results In this paper, we study strategies under a logarithmic market scoring rule (LMSR) in a Bayesian extensive-form game setting with incomplete information. We show that different information structures can lead to radically different strategic properties by analyzing two natural classes of signal distributions: conditionally independent signals and unconditionally independent signals. For conditionally independent signals, we show that truthful betting is a Perfect Bayesian Equilibrium in ﬁnite-stage and inﬁnite-stage models. Further, we show that the truthful betting equilibrium is the unique Weak Perfect Bayesian Equilibrium in this setting. Thus, blufﬁng strategies are not a concern. In contrast, when signals are unconditionally independent, we show that truthful betting is not a Weak Perfect Bayesian Equilibrium in the ﬁnite-stage model. In the inﬁnite-stage model, we show that there is no Weak Perfect Bayesian Equilibrium that results in full information revelation in a ﬁnite number of trades. We propose and analyze a discounted version of the LMSR that mitigates the strategic hazard. In the discounted LMSR, we prove that under any WPBE strategy, the relative entropy between the market price and the optimal full-information price tends to zero at an exponential rate. The rate of convergence can be bounded in terms of the discounting parameter and a measure of complementarity in the information setting. 1.2 Related Work Theoretical work on price manipulation in ﬁnancial markets [1, 7, 23] explains the logic of manipulation and indicates that double auctions are not incentive compatible. This literature has studied manipulation based on releasing false information (perhaps through trades in other markets), as well as manipulation that only requires strategic manipulation in a single market. The latter form of manipulation is closely related to our study here. Allen and Gale [1] describe a model in which

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a manipulative trader can make a deceptive trade in an early trading stage and then proﬁt in later stages, even though the other traders are aware of the possibility of deception and act rationally. They use a stylized model of a multi-stage market; in contrast, we seek to exactly model a market scoring rule model. Apart from other advantages of detailed modeling, this allows us to construct simpler examples of manipulative scenarios: Allen and Gale’s model [1] needs to assume traders with different risk attitudes to get around no-trade results, which is rendered unnecessary by the inherent subsidy with a market scoring rule mechanism. Our model requires only risk-neutral traders and exactly captures the market scoring rule prediction markets. We refer readers to the paper by Chakraborty and Yilmaz [7] for references to other research on manipulation in ﬁnancial markets. There are some experimental and empirical studies on price manipulation in prediction markets using double auction mechanisms. The results are mixed, some giving evidence for the success of price manipulation [19] and some showing the robustness of prediction markets to price manipulation [6, 22, 29, 30]. Feigenbaum et al. [15] also study prediction markets in which the information aggregation is sometimes slow, and sometimes fails altogether. In their setting, the aggregation problems arise from a completely different source: the traders are nonstrategic but extracting individual traders’ information from the market price is difﬁcult. Here, we study scenarios in which extracting information from prices would be easy if traders were not strategic; the complexity arises solely from the use of potentially non-myopic strategies. Nikolova and Sami [27] present an instance in which myopic strategies are not optimal in an extensive-form game based on the market, and suggest (but do not analyze) using a form of discounting to reduce manipulative possibilities in a prediction market. Axelrod et al. [2] also propose a form of discounting in an experimental parimutuel market and show that it promotes early trades. Unlike the parimutuel market, the market scoring rule has an inherent subsidy, so it was not obvious that discounting would have strategic beneﬁts in our setting as well. B¨ rgers et al. [5] study when signals are substitutes and complements in a o general setting. Our equilibrium and convergence result suggests that prediction markets are one domain where this distinction is of practical importance. This paper is a synthesis and extension of two independent sets of results, which were presented in preliminary form by Chen et al. [10] and Dimitrov and Sami [13]. 1.3 Structure of the Paper This article is organized as follows: In section 2, we present a little background information about market scoring rules. Section 3 details our formal model and information structures. In Section 4 we investigate how predeﬁned sequence of play affects players’ expected proﬁts in LMSR. In Section 5 we consider, when a player can choose to play ﬁrst or second, what is its equilibrium strategy in a 2-player LMSR. Results of Sections 4 and 5 serve as building blocks for our analysis in subsequent sections. Section 6 studies the equilibrium of a 2-player,

market scoring rules are known to guarantee that the market maker’s loss is bounded. Section 9 proposes a discounted LMSR and analyzes how the mechanism discourages non-truthful behavior. An MSR market can be equivalently implemented as a market maker offering n securities. .Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 5 3-stage game. . if a trader can only change the probability estimate once. rn is a reported probability estimate for the random variable X. (1) is used. The market maker uses a proper scoring rule. Finally. this modiﬁed proper scoring rule still incentivizes the trader to reveal its true probability estimate. 2. If a trader with probability ˜ moves the r market probability from r to ˜. we conclude in Section 10. they might have incentive to manipulate information and mislead other traders. Because traders change the probability estimate in sequence. Subsidizing a market to predict the likelihood of each outcome. . changing the market probability of outcome i to some value ri is the same as buying the security for outcome i until the market price of the security reaches ri . every trader in the market may change the current probability estimate to a new estimate of its choice at any time as long as it agrees to pay the scoring rule payment associated with the current probability estimate and receive the scoring rule payment associated with the new estimate. However. A trader’s expected proﬁt in LMSR directly corresponds to the concept of relative entropy in information theory. where r = r1 . S = {s1 (r). . If outcome i is realized. 2 Background Consider a discrete random variable X that has n mutually exclusive and exhaustive outcomes. Our analysis in this paper is facilitated by directly dealing with probabilities. Conceptually. called market scoring rules (MSR). A popular MSR is the logarithmic market scoring rule (LMSR) where the logarithmic scoring rule si (r) = b log(ri ) (b > 0). We generalize this result to arbitrary ﬁnite-player ﬁnite-stage games in Section 7. 21] shows how a proper scoring rule can be converted into a market maker mechanism. sn (r)}. . r r Since a proper scoring rule is incentive compatible for risk-neutral agents. ˜) = r i=1 ri (si (˜) − si (r)) = b ˜ r ri log ˜ i=1 ri ˜ = bD(˜||r). We analyze inﬁnite-stage games in Section 8. Hence. 9]. . when traders can participate multiple times. . . The market maker pays the last trader and receives payment from the ﬁrst trader. each corresponding to one outcome and paying $1 if the outcome is realized [20. its expected proﬁt (score) in LMSR is r n n S(r. MSR can be thought of as a sequential shared version of the scoring rule. a trader that changes the probability estimate from r to ˜ pays si (r) and receives si (˜). r ri (2) .1 Market Scoring Rules Hanson [20.

P : Ω×C1 ×· · ·×Cm → [0. without loss of generality we assume that b = 1 in the rest of the paper.6 Y. with the intent of capitalizing on their resultant misinformed trading. Blufﬁng is the strategy of betting contrary to one’s information in order to deceive future traders. it is the strategy of always buying immediately when the price is too low and selling when the price is too high. about the state of the world at the beginning of the market. 3. N } is the state space of this event. ω ∈ Ω.1 3 LMSR in a Bayesian Framework In this part. 1]. A market. Pr(ω = N ) . The actual realization of the signal is observed only by the player receiving the signal. D(p||q) is the relative entropy or Kullback Leibler distance between two probability mass functions p(x) and q(x) and is deﬁned in [11] as D(p||q) = x p(x) log p(x) . is common knowledge. p0 = Pr(ω = Y ). Ci is the signal space of player i with |Ci | = ni . because the market degenerates to a race to capitalize on the shared information ﬁrst. we introduce our game theoretic model of LMSR market in order to capture the strategic behavior in LMSR when players have private information. is picked by nature according to a prior p0 = p0 .2 Terminology Truthful betting (TB) for a player in MSR is the strategy of immediately changing the market probability to the player’s believed probability. Since b is a scaling parameter. q(x) D(p||q) is nonnegative and equals zero only when p = q. rN . and too high when current expected payoff is lower than the price. ci . There are m risk neutral players in the market. Chen et al. Ω = {Y. This paper investigates scenarios where traders with incomplete information have an incentive to deviate from truthful betting. “Too low” and “too high” are determined by the player’s information. 1 With complete information. The joint distribution of the true state and players’ signals. . Truthful betting fully reveals a player’s payoff-relevant information.1 General Settings We consider a single event that is the subject of our predictions. traders should reveal all information right away in MSR. uses a LMSR market maker with initial probability 0 0 estimate r0 = rY . 2. In other words. aiming at Y N predicting the true state ω. Each player i gets a private signal. The maximum amount a LMSR market maker can lose is b log n. The price is too low when the current expected payoff is higher than the price. The true state.

we further assume that conditionally independent signals are informative and distinct. Formally. players’ signals are assumed to be independent conditional on the state of the world. Suppose the problem for a prediction market is to predict whether a batch of product is manufactured with high quality materials or low quality materials. If the product is manufactured with low quality materials. Some consumers who each bought a product have private observations of whether their products break in the ﬁrst month of use.1 Games with Conditionally Independent (CI) Signals We start with a concrete example before formally introducing the model for conditionally independent signals. as well as the observed prices after the ﬁrst k − 1 trades. In order to rule out degenerated cases. We study two models of independence – independence conditional on the true state. in the LMSR market. and ∀i. If a player i is designated to trade at some stage k in the sequence.When two signals give a player the same posterior. 3. ∀1 ≤ i ≤ m and ∀a ∈ Ci .e. when observing a signal does not change a player’s belief. Player i has distinct signals when its posterior probability is different after observing different signals.. If the product is manufactured with high quality materials. It turns out that the strategic analysis of the market depends critically on independence properties of players’ signals. and analogously p(ci |N ) if the true state is N . in games with conditionally independent signals. cj |ω) = Pr(ci |ω) Pr(cj |ω) is always satisﬁed by P. Intuitively.Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 7 Players trade sequentially. These are described below. . signals are distinct if and only if Pr(ω = Y |ci = a) = Pr(ω = Y |ci = a ). An informative signal means that after observing the signal. we have not made any assumptions about the joint distribution P. Formally. a = a . This is an example where consumers have conditionally independent signals – conditional on the quality of the materials. Conditionally independent signals are usually appropriate for modeling situations where the true state of the world has been determined but is unknown. signals are informative if and only if Pr(ci = a|ω = Y ) = Pr(ci = a|ω = N ). Formally. the probability for a product to break in its ﬁrst month of use is 0. a ∈ Ci . for any two players i and j. consumers’ observations are independent.1. and signal realizations are inﬂuenced by the true state of the world. This class can be interpreted as player i’s signal ci is independently drawn by nature according to some conditional probability distribution p(ci |Y ) if the true state is Y . in one or more stages of trading. and unconditional independendence – that are both natural in different settings. conditioned on the eventual outcome of the event. it can condition its beliefs of the likelihood of an outcome on its private signals. we can combine these two signals into one because they provide same information. The quality of the materials will be revealed by a test in the future. Pr(ci . i.1. we can simply remove the signal from the player’s signal space because it does not provide any information. Up to this point.01. a player’s posterior is different from its prior. ∀a. In other words. Players are risk-neutrual Bayesian agents. the probability for a product to break in its ﬁrst month of use is 0.

which can arguably be thought as independent of each other. ∀i = i. For m > 2. which contradicts the informativeness of signals. Then. Lemma 1 If players have informative signals that are conditionally independent. signals of players i and j. Pr(ci = a. they might stochastically inﬂuence the eventual outcome of the event. j) = . j = j : Pr(Y |c1 = i. the following property must be true: ∀i. This is an example of a game with unconditionally independent signals. signal realizations are not caused by the state of the world. we primarily prove results about the lack of truthful equilibria. we must have ∀j. Chen et al. but instead. we will often invoke the following general informativeness condition. i ∈ C1 and ∀j. Formally. in a political election prediction market. for m = 2.2 Games with (Unconditionally) Independent (I) Signals In some other situations. Such results require us to show that there is a strict advantage to deviate to an alternative strategy. j ∈ C2 such that i = i . In order to rule out degenerate cases in which the inequalities are not strict.1. The above expression equals 0 only when Pr(ci = a|Y ) − Pr(ci = a|N ) = 0 or Pr(cj = b|Y ) − Pr(cj = b|N ) = 0 or both. voters’ private information is their votes. Pr(ci . Pr(ci = a. c2 = j) = Pr(Y |c1 = i . cj ) = Pr(ci ) Pr(cj ) is always satisﬁed by P. Formally. Hence. Deﬁnition 1 An instance of the prediction market with m players and joint distribution P satisﬁes the general informativeness condition if there is no vector of signals for any m − 1 players that makes the mth player’s signals reveal no distinguishing information about the optimal probability. Pr(Y |i. For instance. are unconditionally independent. cj = b) − Pr(ci = a) Pr(cj = b) = 0 must be satisﬁed for all a ∈ Ci and b ∈ Cj . cj = b) − Pr(ci = a) Pr(cj = b) = Pr(ci = a.8 Y. 3. their signals are unconditionally dependent. For games with independent signals. c2 = j). By conditional independence of signals. c2 = j) = Pr(Y |c1 = i. ci and cj . cj = b|ω = z) Pr(ω = z) Pr(ci = a|ω = z) Pr(ω = z) z z z − = z Pr(cj = b|ω = z) Pr(ω = z) Pr(ci = a|ω = z) Pr(cj = b|ω = z) Pr(ω = z) − Pr(ci = a|ω = z) Pr(ω = z) z z Pr(cj = b|ω = z) Pr(ω = z) = Pr(Y ) Pr(N ) (Pr(ci = a|Y ) − Pr(ci = a|N )) (Pr(cj = b|Y ) − Pr(cj = b|N )) . for any two players i and j in games with independent signals. Lemma 1 shows that conditional independence implies unconditional dependence. c2 = j ) and Pr(Y |c1 = i. ci and cj are unconditionally dependent. Proof Suppose the contrary. The election outcome – which candidate gets the majority of votes – is determined by all votes.

We do not consider the case when signals are both conditionally dependent and unconditionally dependent. In this paper. [25]. is a Weak Perfect Bayesian Equilibrium (WPBE) if and only if. for each player. j). we use the WPBE concept. when giving a speciﬁc equilibrium. conditional independence and unconditional independence. When proving the nonexistence of truthful betting equilibrium and characterizing the set of all equilibria. Informally. Frequently. An assessment proﬁle (A1 . and j is a vector of signals for the other m − 1 players. By Lemma 1. where i. that we discuss in this paper are mutually exclusive. which further require beliefs at nodes that are off the equilibrium path to be consistent. consisting of an assessment for each player. are used.. The belief system component of an assessment speciﬁes what a player believes at each node of the game tree. but not exhaustive. every node that is reached with positive probability).. Specifying a plausible play of the game involves specifying not just the moves that players make for different information signals. We allow for strategies to be (behaviorally) mixed. the reﬁned concepts of Perfect Bayesian Equilibrium (PBE) or sequential equilibrium. i are two possible signals for any one player. 3.Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 9 Pr(Y |i . . The strategy dictates what move the player will make at each node in the game tree at which she has to move. the strategies are sequentially rational given their beliefs and their beliefs at any node that is reached with nonzero probability are consistent with updating their prior beliefs using Bayes rule. the belief systems of the players are completely deﬁned at every node on the equilibrium path (i. contingent on reaching the node.. We will abuse notation slightly by simply referring to an “equilibrium strategy proﬁle”. the belief at a node consists of probabilities of other players’ signal realizations. For a formal deﬁnition of the equilibrium concepts. because the results thus hold a fortiori for reﬁnements of the WPBE concept. but also the beliefs that they have at each node of the game tree. µi ) for a player i consists of a strategy σi and a belief system µi . This is a relatively weak notion of equilibrium for this class of games. we will not consider players’ beliefs off the equilibrium path for WPBEs. Am ). . given the strategies. we use the reﬁned PBE concept. indeed. we know that unconditional independence implies conditional dependence. Given the strategy components of a WPBE proﬁle.2 Equilibrium Concepts The prediction market model we have described is an extensive-form game between m players with common prior probabilities but asymmetric information signals. we make the mild assumption that a player’s strategy can randomize over only a ﬁnite set of actions at each node. we refer the reader to the book by Mas-Colell et al.e. Thus.. an assessment Ai = (σi . the only relevant information a trader lacks is the value of the other trader’s information signal. a blufﬁng equilibrium must involve mixed strategies. In the remainder of this paper. In our setting. We note that the two information structures. To avoid technical measurability issues.

Two speciﬁc ﬁrst-stage strategies we will study are the truthful strategy (denoted σ T ) and the null strategy (denoted σ N ). We answer the question: when two players play myopically according to a predeﬁned sequence of play.. are the players better off on expectation by playing ﬁrst or second? In particular.10 Y. a ﬁrst-stage strategy σ1 for the ﬁrst player is a speciﬁcation. For PBEs.. 4 Proﬁts under Predeﬁned Sequence of Play In this section.. . where r1 . but we include a proof for completeness. µi ). we consider two players playing in sequence and deﬁne some notations of strategy and expected proﬁts to facilitate our analysis on how the proﬁt of the second player depends on the strategy employed by the ﬁrst player. if stage t is player i’s last chance to play and µi is player i’s belief over actions of previous players. Although we are studying 2-stage games here. of a mixed strategy over moves. we investigate how sequence of play affects players’ expected profits in LMSR. The null strategy speciﬁes that. so the deﬁnitions are more general and the ﬁrst player’s strategy may not be truthful. µi ) .. we will explicitly explain players’ beliefs in proofs. r1 . we use them as a building block for our results in subsequent sections. . player i’s best response at stage t is to play truthfully by changing the market probabilities to rt = Pr(Y |ci . In a 2-stage game in which Alice plays ﬁrst. for each possible signal received by that player. we use notation π B (σ1 ) to denote Bob’s expected myopic optimal proﬁt following a ﬁrst-stage strategy σ1 by Alice. regardless of its signal ci . Note that π B (σ N ) is equal to the expected myopic proﬁt Bob would have had if he had moved ﬁrst. assuming that Bob knows the strategy σ1 and can condition on it.. rt−1 . in a game in which Alice moves after Bob. . the ﬁrst player leaves the market probability unchanged. Pr(N |ci . rt−1 are the market probability vectors before player i’s action. rt−1 . the same as she found it at. Deﬁnition 2 Given a game and a sequence of play. Lemma 2 In a LMSR market. We begin with the following simple result showing that the truthful strategy is optimal for a player moving only once. π B (σ T ) is the proﬁt that Bob earns when Alice follows her myopically optimal strategy. The truthful strategy speciﬁes that. Also. for each signal ci it receives.. In fact. our analysis apply to the ﬁrst two stages of any game.. r1 . followed by Bob. because under the null strategy σN Alice does not move the market. for WPBEs. This follows from the myopic optimality of LMSR. the ﬁrst player changes market probability to its posterior belief after seeing the signal. Chen et al... we use π A (σ1 ) to denote Alice’s expected proﬁt. Likewise. leaving the beliefs implicit. .

Recall that the moves are actually probability distributions. The total proﬁt of two consecutive moves.Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 11 Proof When a player has its last chance to play in LMSR. Since the state of the world has only two exclusive and exhaustive outcomes. and. we set σ1 to dictate that Alice move to x = qx instead. and because Bob can infer x from x. The intuitive argument we use is as follows: Consider the situation in which Alice is known to be following strategy σ1 . likewise. Because the logarithmic scoring rule is strictly proper. in a market using the LMSR. and other notation is deﬁned similarly. ω = z). ˆ We start by setting σ1 = σ1 . By ˆ ˆ ˆ ˆ deﬁnition of x. as follows. we may write expressions like x x in which ˆ ˆ x is implicitly indexed by x. Bob moves the market from x to his posterior probability ˆ ˆ P r(z|x. Alice following σ1 ). the probability of the outcome Y occuring conditioned on σ1 and the fact that Alice moved to x is exactly equal to x. thus resulting in a consistent strategy σ1 . Let qx = P r(Y |xA = x. Note that any x has ˆ ˆ ˆ ˆ a corresponding value of x. We use the term position to refer the market probability for outcome Y . thus contradicting the ˆ σ minimality of σ1 . In the second step. player i’s expected utility is maximized by truthfully reporting its posterior probability estimate given the information it has. Next. ˆ The actual position that Alice moves to can be thought of as a random variable on a sample space that includes the randomly-distributed signals Alice receives as well as the randomization Alice uses to play a mixed strategy. cB = ˆ b. We use Pr(x. whenever σ1 dictates that Alice move to x. We construct a perturbed ﬁrst-stage strategy σ1 . is exactly the payoff of moving from the starting point to the end point of the second move. The market probability for outcome N is then uniquely deﬁned because the probabilities for the two outcomes sum to 1. N }. thus. Then. it is the same as the player interacting with a logarithmic scoring rule. xz = Pr(ω = z|xA = x. Note that the second step alone yields Bob at least π B (ˆ1 ) in expectation. ˆ the event ω is a random variable that takes on two values {Y. xN = 1 − x. Bob’s actual proﬁt is the sum of his proﬁt from these two steps. because in σ both cases the move begins at x. σ1 satisﬁes the following consistency condition: For any position x that Alice moves to under σ1 . Hence. Bob moves the market to the corresponding x. for any given position x that Alice leaves the market price at. In order to use summation notation. We ˆ ˆ repeat this perturbation for each x such that x = qx . b). Then. Such a σ1 is easily constructed from any given σ1 . and show that π B (ˆ1 ) < π B (σ1 ). we deﬁne xY = x. and for which the consistency condition is failed. we decompose Bob’s response into two virtual steps. Proof Suppose that σ1 does not satisfy this condition. Lemma 3 Let σ1 be a ﬁrst-stage strategy for Alice that minimizes the expression π B (σ) over all possible σ. Y and N . we provide a lemma that is very useful for obtaining subsequent theorems. z) to represent Pr(xA = x. We further ˆ ˆ argue that the ﬁrst step yields a strictly positive expected proﬁt. because for any . We use xA and xA ˆ to denote random variables that takes on values x and x respectively. Alice following σ1 ). Similarly. b. xY = x. xN = 1 − x. Consider any one position x that Alice moves to with ˆ positive probability under strategy σ1 . In the ﬁrst virtual step.

b)D(p(ω|xA . π B (σ1 ) − π B (ˆ1 ) = σ x.cB ) are the conditional distributions of ω. we will prove that. z) [log xz − log xz ] ˆ Pr(z|x.cB ) ||p(ω|ˆA . Hence. this always yields a positive expected proﬁt in the LMSR. Thus.b Pr(x. position x. b)] x Pr(z|x) [log xz − log xz ] ˆ + x. there is at least one x such that Pr(x) > 0 and x = x. z) [log Pr(z|x.b. which is x x known to be nonnegative and strictly positive when the two distributions are not the same. 4.cB ) and p(ω|ˆA . b)D(p(ω|xA .b. for any strategy σ1 that Alice chooses. if Bob is aware that Alice is following strategy σ1 .b. b. b) − log Pr(z|ˆ. and thus.b Pr(x. b) − log xz ] Pr(x.z Pr(x. We assumed that σ1 does not meet the consistency condition.cB ) ) and D(p(ˆA ) ||p(xA ) ) are relative entropy.1 Proﬁts in CI Games When Alice and Bob have conditionally independent signals and Alice plays ﬁrst. b) − log Pr(z|ˆ. b)] x Pr(x. b. z) [log Pr(z|ˆ. z) [log Pr(z|x. b. his expected payoff from following the myopic strategy (after conditioning his beliefs on Alice’s actual move) is at least as much as he could expect if Alice had chosen to play truthfully.cB ) ||p(ω|ˆA .12 Y. This contradicts the minimality σ x assumption of σ1 . Formalizing this argument. we have ˆ D(p(ˆA ) ||p(xA ) ) > 0. The ﬁrst step thus moves ˆ the market from a less accurate value to the most accurate possible value given information x. Chen et al. and x p(ˆA ) and p(xA ) are the probability distributions of xA and xA respectively.cB ) ) x Pr(x)D(p(ˆA ) ||p(xA ) ) x + x where p(ω|xA .cB ) ) x Pr(x) x z + = x.cB ) ||p(ω|ˆA . b.b. b) z + x Pr(x) z = x. ˆ x D(p(ω|xA . .b xz [log xz − log xz ] ˆ ˆ Pr(x. the posterior probability of outcome Y is xY . π B (σ1 ) > π B (ˆ1 ).z = x. b) − log xz ] x ˆ − = x. we compare the payoffs π B (σ1 ) and π B (ˆ1 ) as σ follows.z Pr(x.z x. b) [log Pr(z|x.

Let us analyze Bob’s expected payoff when Alice follows this strategy σ1 . A fundamental result from information theory states that xA can reveal no more information about cB than cA can. Theorem 1 For any CI game G with Alice playing ﬁrst and Bob playing second. we can assume that σ1 is consistent. z) [log yz (x. b). Pr(ci |Y ) Pr(Y |cj ) + Pr(ci |N ) Pr(N |cj ) Proof Using Bayes rule. Bob will move to a position y(x. Alice’s actual move xA (for outcome Y ) . More speciﬁcally. the equality holds if and only if σ1 = σ T . Alice following σ1 .b. ω = z. we have: π B (σ1 ) = x. However. Y ) Pr(Y |cj ) + Pr(ci |cj . and thus. Pr(ω|ci . cj ) = where ω ∈ {Y. without loss of generality. σ1 . We can view Alice’s signal cA .z Pr(x. we drop σ1 from the notation. Proof We use an information-theoretic argument to prove this result. By deﬁnition of the LMSR. b. observing Alice’s posterior probabilities is equally informative to Bob as observing Alice’s signal directly. Bob’s proﬁt is minimized when xA reveals as much information as cA . When signals are informative and distinct. b) − log xz ] . note that xA is a (perhaps randomized) function of Alice’s signal cA alone. N ) Pr(N |cj ) Pr(ci |ω) Pr(ω|cj ) = . if player i knows player j’s posterior probabilities Pr(Y |cj ). By Lemma 4. the lower Bob’s expected proﬁt. player i can infer the posterior probabilities conditional on both signals. For conciseness. plus another term that does not depend on Alice. The more information that xA reveals about cB . cj ) = = Pr(ω. N }. Pr(ci |ω) Pr(ω|cj ) . attains the minimum. ω) Pr(ω|cj ) Pr(ci |cj . By Lemma 3.Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 13 First. cB = b). xA = x. cB = b. and thus. We now formalize this argument. retaining the notation above. and thus. Pr(ci |cj . b) = Pr(Y |xA = x. Pr(N |cj ) . Lemma 4 When players have conditionally independent signals. the truthful strategy for Alice reveals all information that is in cA . and any σ1 . ci |cj ) Pr(ci |cj ) The third equality comes from the CI condition. π B (σ1 ) ≥ π B (σ T ). we show that in CI games. and write y(x. The unit of our analysis is a particular realization of a combination cA = a. the event ω as random variables. we have Pr(ω|ci . We then show that Bob’s expected payoff can be characterized as the entropy of cB conditioned on observing xA . Pr(ci |Y ) Pr(Y |cj ) + Pr(ci |N ) Pr(N |cj ) We can now prove our result on Bob’s myopic proﬁt in the CI setting. Bob’s signal cB . the lower the conditional entropy H(cB |xA ). As before use xz and yz to denote the probability of ω = z inferred from positions x and y respectively.

For the ﬁrst term. we can write π B (σ1 ) = −H(ω. The second term is clearly independent of σ1 . Using the relation H(X. it is immediate that b Pr(b|x. and thus. cB ) + H(ω. 35]. b) log Pr(z|x. b) z Pr(z|x. cB ) − H(ω. Further. xA . xA ) = H(cB |xA ) − H(cB |ω) = [H(xA .b Pr(x. Expanding.14 Y. 17]. we have π B (σ1 ) = x. Chen et al. More specifically. b) z Pr(z|x. b) = Pr(ω = z|x. we note that H(cB |cA ) ≤ H(cB |xA ) because xA is a function of cA [11. b) log yz (x. Next. z) log xz Pr(x. Y ) = H(X) + H(Y |X). b) Pr(z|x) z b − = x. b) Pr(z|x) log Pr(z|x) z − Pr(x) x = −H(ω|xA . we note that yz (x. cB ) + H(xA . xA ) − H(xA ) = H(cB |xA ) − H(cB |ω. cB ) − H(xA )] − [H(ω. xA )] The last transformation H(cB |ω. xA . H(cB |xA ) = − =− ≥− =− =− Pr(x) x b Pr(b|x) log Pr(b|x) Pr(a|x) Pr(b|a) log b a a Pr(x) x Pr(a|x) Pr(b|a) Pr(x) x b a [Pr(a|x) Pr(b|a) log Pr(b|a)] Pr(a|x) a b Pr(x) x [Pr(b|a) log Pr(b|a)] Pr(a) a b Pr(b|a) log Pr(b|a) = H(cB |cA ). pg. z) = 1. cB ) + H(ω|xA ) where we have identiﬁed the terms with the standard deﬁnition of conditional entropy of random variables [11. b). pg. . xA ) = H(cB |ω) follows because cB is conditionally independent of xA conditioned on ω. knowledge of xA does not alter its conditional distribution or its conditional entropy.b Pr(x) x Pr(b|x.

Hence. Bob is better off when the Bob-Alice sequence is used. Proof We compare Bob’s expected proﬁt in Alice-Bob and Bob-Alice cases when both players play myopically. ax = ax because signals are distinct. the condition is satisﬁed with Pr(cA = a|xT = xa ) = 1. when cA = a. Alice moves to Pr(Y |cA = a) with probability 1 under σ1 . Corollary 1 In CI games. the equality holds only when σ1 is a strategy such that for any x there exists some a that satisﬁes Pr(cA = a|xA = x) = 1. This means that Pr(Y |cA = ax ) = Pr(Y |cA = ax ) when x = x . Given any signal a that Alice might see. and let xT denote the corresponding random variable. A All that remains to be shown is that there is no other strategy σ1 = σ T that satisﬁes the condition. cA and cB are unconditionally independent which contradicts with the CI condition by Lemma 1. it is better off for a player to play ﬁrst than second. The equality holds only when the distribution of cB |a is the same as the distribution of cB |a for all a. If with some positive probability xA = x = Pr(Y |cA = a). it must be that ax = ax . for all a ∈ CA . Because signals are distinct. or for any x there exists some a such that Pr(cA = a|xA = x) = 1. strategy σ1 is the truthful strategy σ T . for any strategy σ1 that Alice chooses. Thus. According to Lemma 3. Pr(Y |xA = x. x ∈ XA . According to Theorem 1. when two players play myopically according to a predeﬁned sequence of play. we show that when cA = a. For some strategy σ1 . Suppose the contrary. π B (σ N ) > π B (σ T ). Hence. Next. then. we will prove that. The following corollary immediately follows from Theorem 1 and answers that question we proposed at the beginning of the section for CI games. We ﬁrst show that when x = x and x.2 Proﬁts in I Games When Alice and Bob have unconditionally independent signals and Alice plays ﬁrst. Bob’s expected proﬁt in Alice-Bob case equals π B (σ T ). while his expected proﬁt in Bob-Alice cases equals π B (σ N ). 4. Then xa = A Pr(Y |cA = a). it must be the case that xA = Pr(Y |cA = a) with probability 1 according to strategy σ1 . Alice follows σ1 ) = x. cA = ax = a. If cB |a and cB |a have the same distribution for all a and a . the value of xa uniquely corresponds to signal a. if Bob is aware that Alice is following strategy σ1 . his expected payoff from following the myopic strategy (after conditioning his beliefs on Alices actual move) is at least as much as he could expect if Alice had chosen to play the null strategy σ N . for any x ∈ XA there exists ax such that Pr(cA = ax |xA = x) = 1. Hence. Thus. which gives a Pr(Y |cA = a ) Pr(cA = a |xA = x) = x =⇒ Pr(Y |cA = ax ) = x. let XA denote the value space of xA . because Pr(cA = ax |xA = x ) = 1.Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 15 The inequality follows from the strict convexity of the function x log x. let xa be the position that Alice would move to if she followed the truthful strategy. Hence. The truthful strategy σ T satisﬁes the above condition. and contradiction arises. . a ∈ CA .

i. Pr(ω = N ) . without loss of generality. if the market starts with the prior probabilities for the two outcomes. cB = bj ). and pF the probability that Alice has signal cA = ai and sets xA = H equals pE uEi +uFi . cB = bj ). and the same set of remaining points R. π B (σ1 ) = (pE − pF )[ +pF [ j j Pr(cB = bj )D(rα || j j Pr(cB = bj )rα )] j j Pr(cB = bj )D(rα || j Pr(cB = bj )D(rβ || j Pr(cB = bj )rα )] j Pr(cB = bj )rβ )] j j +pF [ j + remaining proﬁt over R . In this case. Alice mixes over E and H with probability pE − pF and 2pF respectively. Chen et al. We will show that σ1 must involve Alice not moving the market probability at all. Deﬁne uEi and uFi as the probability (under σ1 ) that Alice has signal cA = ai and sets xA = E and xA = F respectively. it can only have a single value. Let pE be the probability that Alice plays E and similarly pF be the probability that Alice plays F . writing pE as (pE − pF ) + pF to facilitate comparison with π B (σ1 ). Let xA be the random variable of Alice’s move for outcome Y under strategy σ1 . then σ1 would have support over a set of points: at least two points E. With these deﬁnitions we E F can deﬁne the myopic move of Bob given that market is at E and cB = bj as β α rj = αi Pr(Y |cA = ai . we have π B (σ1 ) ≥ π B (σ N ). Deﬁne αi = Pr(cA = ai |xA = u u E) = pEi and βi = Pr(cA = ai |xA = F ) = pFi . and consider a new strategy σ1 over points E. Similarly rj is deﬁned as the myopic move of Bob given the market is at F . 1 − rj respectively. let H = (E + F )/2 be the midpoint of E and F . pF pE uEi +uFi 2pF = 1 uEi 2 pE + 1 u Fi 2 pF = We can now deﬁne the myopic move of Bob given the market is at H γ and cB = bj as rj = γi Pr(Y |cA = ai . Proof Assume that there is a strategy σ1 for Alice that minimizes π B (σ1 ) over all possible ﬁrst-stage strategies. Now. −p the probability that Alice has signal cA = ai and sets xA = E is pEpE F uEi . we use rγ to j i represent the vector for two outcomes.16 Y. H. and perhaps a set of other points R.e. F . We ﬁrst argue that xA is deterministic. r0 = Pr(ω = Y ). The equality holds if and only if σ1 = σ N . i. Hence. Without loss of generality let pF < pE . We now characterize π B (σ1 ) as follows.e. we show that we can construct a strategy σ1 such that π B (σ1 ) < π B (σ1 ) by “mixing” point E and another point H. 1 − rj and rj . Suppose the contrary. We use rα and rβ to denote the probability j j β β α α vectors for two outcomes rj . i As before we can deﬁne γi = Pr(cA = ai |H) = αi +βi 2 . Theorem 2 For any I game G with Alice playing ﬁrst and Bob playing second and any ﬁrst-stage strategy σ1 . According to Lemma 3. Under σ1 . Similarly. we can assume that σ1 is consistent.

Therefore the strategy that minimizes the expected payoff of Bob is for Alice to report Pr(ω = Y ). The following corollary immediately follows from Theorem 2 and answers the question we proposed at the beginning of the section for I games. This again contradicts the fact that σ1 minimizes π B (σ1 ). x. as Bob will always make a positive payoff in expectation if he moves from x to Pr(ω = Y ). 2 From the deﬁnitions of the myopic moves given the market states. Suppose that the point in the support. .Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 17 We also characterize π B (σ1 ) as: π B (σ1 ) = (pE − pF )[ +2pF [ j j Pr(cB = bj )D(rα || j j Pr(cB = bj )rα ) j j Pr(cB = bj )D(rγ || j Pr(cB = bj )rγ ) j + remaining proﬁt over R rα +rβ j j . Thus. because the market starts with Pr(ω = Y ). the strategy does not reveal any information to Bob. he would have a larger payoff overall if Alice left the market at x instead of Pr(ω = Y ). Thus. is such that x = Pr(ω = Y ). the strategy must have only one point in its support. there always exists a strategy σ1 such that π B (σ1 ) < π B (σ1 ). note that rγ = j This means that π B (σ1 ) can be bounded as : j π B (σ1 ) = (pE − pF )[ +2pF [ j Pr(cB = bj )D(rα || j bj )D(rγ || j j Pr(cB = bj )rα ) j j Pr(cB = Pr(cB = bj )rγ ) j Pr(cB = bj )rα ) j j + remaining proﬁt over R = (pE − pF )[ Pr(cB = bj )D(rα || j j +2pF [ j Pr(cB = bj )D( rα + rβ j j 2 || Pr(cB = bj ) j rα + rβ j j 2 ) + remaining proﬁt over R < (pE − pF )[ Pr(cB = bj )D(rα || j j Pr(cB = bj )rα )] j j +pF [ j Pr(cB = bj )D(rα || j Pr(cB = bj )D(rβ || j Pr(cB = bj )rα )] j j +pF [ j Pr(cB = bj )rβ )] j j + remaining proﬁt over R = π B (σ1 ) The last inequality follows from the strict convexity of relative entropy under the general informativeness condition. This means that for any strategy of Alice that minimized π B (σ1 ). for any strategy σ1 with two or more points in its support. Therefore we have shown that π B (σ1 ) ≥ π B (σ N ). it is equivalent to her not trading at all in the ﬁrst stage. Therefore. However. Only when σ1 = σ N the equality holds.

Pr(N |cA ) in the second stage. π B (σ T ) ≥ π B (σ N ). Hence. Bob’s belief µB gives . cB ) in the third stage. we examine the following strategic question: Suppose that each player will get to report only once. That is. Pr(N |cA .1 Sequence Selection Equilibrium of CI Games Consider the sequence selection game. Bob’s expected proﬁt in Alice-Bob case equals π B (σ T ). we deﬁne a simple 2-player sequence selection game. Theorem 3 When Alice and Bob have conditionally independent signals in LMSR. Proof We compare Bob’s expected proﬁt in Alice-Bob and Bob-Alice cases when both players play myopically. where ai is the i-th element of CA . Chen et al. After getting their signals. and assume that Alice and Bob have conditionally independent signals. when two players play myopically according to a predeﬁned sequence of play. r0 = Pr(ω = Y ). i. while his expected proﬁt in Bob-Alice cases equals π B (σ N ). . We denote x = x1 . we provide equilibria of the sequence selection game under CI setting and I setting respectively.e. xnA as the vector of Alice’s possible posteriors for the outcome Y . Similarly.. – Alice changes the market probability to Pr(Y |cA ). Proof Since we use the PBE concept. which one should it choose? To answer the question. Bob gets a signal cB . 5 Sequence Selection Game In this section. If a player has a choice between playing ﬁrst and playing second after observing its signal. Pr(ω = N ) .. The following theorem gives a PBE of the sequence selection game when the CI condition is satisﬁed. xi = Pr(Y |cA = ai ). – Bob changes the market probability to Pr(Y |cA . assume that xi < xj iff i < j. Then. it is better off for a player to play second than ﬁrst. In the third stage. Off the equilibrium path. Alice gets a signal cA . According to Theorem 2. The selected player then changes the market probabilities as they see ﬁt in the second stage. the market closes and the true state is revealed. Without loss of generality. 5.. In the rest of this section. Suppose that Alice and Bob are the only players in the market. when Alice selects Bob to be the ﬁrst player and the initial market probability is r0 . Alice chooses who— herself or Bob—plays ﬁrst. we ﬁrst describe Bob’s belief µB for the offequilibrium paths. Alice and Bob play the sequence selection game as follows. the other player gets the chance to change the market probabilities. cB ). Bob is better off when the Alice-Bob sequence is used. Corollary 2 In I games that start with the prior probabilities for the two outcomes. In the ﬁrst stage. at a PBE of the sequence selection game – Alice selects herself to be the ﬁrst player in the ﬁrst stage.18 Y.

select herself as the ﬁrst player. cB . mix between selecting herself as the ﬁrst player and selecting Bob as the ﬁrst player. To make her sequence selection in the ﬁrst stage. Alice essentially compares her expected utilities conditional on her own signal in the Alice-Bob and BobAlice subgames. 0 – If cA = ai or cA = ai+1 and xi < rY < xi+1 . µB ) equals one of the following 0 1. 0 3. µB ) = x1 . and ω = z. cB ). Pr(N |a1 . When cA = ai . cB ) when xnA < rY ≤ 1. Then. Pr(Y |r . Pr(N |ˆr0 . Pr(N |ˆr0 ) = r0 . µB ). we use Pr(ak ) . for case 1. z) log l. Pr(N |cA ) in the second stage. Pr(N |cA . Pr(Y |anA . Pr(N |r0 . Bob will further changes the market probabilities to Pr(Y |cA . Pr(Y |r0 . 19 Bob’s belief µB is consistent with Alice’s off-equlibrium mixed strategy: 0 – If cA = ai and xi = rY .z Pr(ω = z|cA = ak ) . µB ). z) represents the joint probability of cA = ak . Pr(Y |r0 . µB ) in the second stage. with probability α select Bob as the ﬁrst player and (1 − α) select herself as the ﬁrst player. cB ) when x1 ≤ rY ≤ xnA . bl . µB ) = xnA . if Bob is selected as the ﬁrst player. 0 0 – If 0 ≤ rY < x1 . select Bob as the ﬁrst player. I UA = 1 Pr(cA = ak ) Pr(ak . bl . cB . believing that prices in the second stage are Alice’s posteriors. cB ) in the third stage. a a ar0 does not necessarily belong to Alice’s signal space CA . select Bob as the ﬁrst player. The mixing probabilities α and β 0 satisfy that Pr(Y |select Bob as the ﬁrst player) = rY . by Lemma 2. a a 0 2. – For all other cases. Pr(Y |r0 . cB = bl ) a where bl represents the l-th signal element in CB . cB ). Pr(N |r0 . and Pr(ak . can calculate his posteriors based on both Alice’s and his own signals. On the contrary. Pr(N |anA . with probability β select Bob as the ﬁrst player and (1 − β) select herself as the ﬁrst player. both of them will truthfully reveal all information that they have given their beliefs when it’s their turn to play. she will change the market probabilities to Pr(Y |cA ). When cA = ai+1 . cB .Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 0 0 – If x1 ≤ rY ≤ xnA . cB = bl . and Pr(ω = z|ˆr0 ) a (3) (4) II UA = 1 Pr(cA = ak ) Pr(ak . Bob. cB = bl ) . Pr(Y |ˆr0 . Let UA denote Alice’s expected proﬁt conditioned on her signal when the Alice-Bob subgame is picked. select Bob as the ﬁrst player.z Pr(ω = z|cA = ak . Pr(Y |a1 . suppose Alice has signal ak . 0 – If xnA < rY ≤ 1. Pr(ω = z|ˆr0 . According to Lemma ˆ 4. he will change the market probabilities to Pr(Y |r0 . 0 – If cA = a1 and 0 ≤ rY < x1 . Let ar0 denote ˆ a ﬁctitious signal realization of Alice that satisﬁes Pr(Y |ˆr0 ). 0 – If cA = anA and xnA < rY ≤ 1. Hence. Each player has only one chance to change the market probabilities. I Without loss of generality. cB . If Alice is the ﬁrst to play. µB ) = rY . cB ). bl . For conciseness. II UA denotes Alice’s expected proﬁt conditioned on her signal when the Bob-Alice subgame is picked. cB ) when 0 ≤ rY < x1 . z) log l. cB ).

We obtain I II UA − UA = 1 Pr(ak ) Pr(ak . D(p||q) ≥ 0. p(cB |ak ) is different from p(cB |ˆr0 ) and hence a I II UA − UA is strictly greater than 0. z) log l. Chen et al. Alice’s expected proﬁt conditioned on her signal for the Bob-Alice subgame becomes II UA = 1 Pr(cA = ak ) Pr(ak . We only need to prove one of them. cB = bl ) . . Pr(N |ak ) = r .z Pr(ω = z|cA = ak . a where p(cB |ak ) is the probability distribution of Bob’s signal conditional on signal ak and p(cB |ˆr0 ) is the probability distribution of Bob’s signal conditional a on the ﬁctitious signal ar0 . Alice does not want to deviate from selecting herself as the ﬁrst player. Without loss of generality. We thus have UA − UA ≥ 0. z) log l. bl . z) log l. cB = bl ) I while UA remains the same as in (3). at a PBE the player will always choose to play ﬁrst in CI games no matter what signal it gets. consider case 0 2 where xnA < rY ≤ 1. z) log l. Theorem 3 further strengthens this result and states that if a strategic player have a choice. cases 2 and 3 are symmetric. The equality holds only II I when distributions p and q are the same. bl ) Pr(ˆr0 ) a Pr(ˆr0 . When 0 Pr(Y |ak ). The difference in expected proﬁts for Alice in the two subgames is: I II UA − UA = 1 Pr(ak ) 1 Pr(ak ) Pr(ak .z Pr(z|ak ) + Pr(z|anA ) Pr(z|ak ) log z Pr(z|anA ) II − UA 0 rz = D p(cB |ak ) ||p(cB |anA ) + Pr(z|ak ) log z Pr(z|anA ) . 0 The second term in the above expression is positive because rY > Pr(Y |anA ) ≥ Corollary 1 in Section 4 indicates that if myopic players follow predeﬁned sequence of play then on expectation a player is better off by playing ﬁrst than second in CI games. bl ) a Pr(z|ˆr0 ) Pr(z|ak . UA − UA > 0.z Pr(z|ak ) Pr(z|ˆr0 . (7) Pr(ω = z|cA = anA . bl . to represent Pr(cA = ak ) and similarly for other terms. Hence. Since the market only has two exclusive outcomes. bl . bl . bl ) Pr(ak ) a (5) = = Pr(ak . The second equality comes from Bayes rule and ˆ the conditional independence of signals.20 Y. 0 rz I II Pr(Y |ak ).z l Pr(bl |ak ) log Pr(bl |ak ) Pr(bl |ˆr0 ) a (6) = D p(cB |ak ) ||p(cB |ˆr0 ) . bl ) a Pr(ak .

bl ) = l Pr(bl ) Pr(z|ak . Theorem 4 If the market starts with the prior probabilities for the two outcomes. assume Alice has signal ak . The following theorem gives a PBE of the sequence selection game when the I condition is satisﬁed. according to Lemma 2.Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 21 5. Pr(z) = l Pr(bl ) Pr(z|bl ). her expected proﬁt conditioned on her sigII nal. Thus. Pr(ω = N ) . Without loss of generality. cB ) in the third stage.z Pr(cb = bl |ak ) Pr(ω = z|ak . bl ). bl ) Pr(ω = z|bl ) (9) = l Pr(cb = bl |ak )D(p(ω|ak . denoted as UA . we need to prove that Alice does not want to deviate from selecting herself as the ﬁrst player. i. cB ). The difference in expected proﬁts for Alice is: I II UA − UA = D(p(ω|ak ) ||p(ω) ) − l Pr(bl )D(p(ω|ak . – Bob changes the market probability to Pr(Y |cB ). her best response in the second stage is to report truthfully. By Bayes rule.e. bl ) log Pr(ω = z|ak .bl ) ||p(ω|bl ) ) Because signals are independent. Bob’s best responds in the second stage is to truthfully report the posterior probability conditioned on his own signal and Alice will report truthfully conditioned on both signals in the third stage. this action does not reveal any information to Bob. Hence. Pr(z|ak ) = l Pr(bl |ak ) Pr(z|ak . the expected proﬁt conditioned on her signal in this I case. – Alice changes the market probability to Pr(Y |cA . Knowing Alice’s strategy. If Alice selects herself as the ﬁrst player.2 Sequence Selection Equilibrium of I games In this part. Pr(N |cB ) in the second stage. is I UA = z Pr(ω = z|ca = ak ) log Pr(ω = z|ca = ak ) = D(p(ω|ak ) ||p(ω) ) (8) Pr(ω = z) If Alice selects Bob as the ﬁrst player. at a PBE of the sequence selection game – Alice in the ﬁrst stage selects Bob to be the ﬁrst player. we consider the alternative model in which players have independent signals.bl ) ||p(ω|bl ) ) l = D( l Pr(bl )p(ω|ak .bl ) ||p(ω|bl ) ) ≤ 0. denoted as UA is II UA = l. r0 = Pr(ω = Y ). and Alice and Bob have independent signals. we have Pr(bl |ak ) = Pr(bl ). Hence. . Pr(N |cA .bl ) || l Pr(bl )p(ω|bl ) ) − Pr(bl )D(p(ω|ak . Proof If Alice always selects Bob as the ﬁrst player.

Pr(N |cA ) in the ﬁrst stage. Bob believes that Alice reports truthfully. – Bob in the second stage changes the market probability to r2 = Pr(Y |cA . cB ) . rN be the market probabilities in stage t. Alice can take another action in the third stage. Pr(N |ak . Lemma 5 characterizes the equilibrium strategy of Alice in the third stage. Built on our equilibrium result for the sequence selection game. Then. Alice behaves truthfully and fully reveals her information. according to Lemma 2 Bob plays truthfully and fully reveals his information.22 Y. Alice does not want to deviate from selecting Bob as the ﬁrst player. The inequality follows from the convexity of relative entropy [11]. her best response is to report her true posterior. at a PBE the player will always choose to play second in I games no matter what signal it gets. t t Let rt = rY . If Alice selects herself to be the ﬁrst players. when Alice has signal ak and Bob has signal bl . Since Bob only gets one chance to play. Chen et al. bl in the third stage. Proof This is proved by applying Lemma 2 to both Bob and Alice. Observing Alice’s action. 6 The Alice-Bob-Alice Game We now consider a 3-stage Alice-Bob-Alice game. at a PBE of the 3-stage Alice-Bob-Alice game – Alice changes the market probability to r1 = Pr(Y |cA ). cB ). . Theorem 4 further strengthens this result and states that if a strategic player have a choice. Because the third stage is Alice’s last chance to change the probabilities. Theorem 5 When Alice and Bob have conditionally independent signals in LMSR. At a WPBE. including her own signal and Bob’s signal inferred from Bob’s action in the second stage. Pr(N |cA . Lemma 5 In a 3-stage Alice-Bob-Alice game in LMSR. the market closes and the true state is revealed. at a WPBE Alice changes 3 3 the market probabilities to r3 = rY . Alice and Bob act as if they know each other’s strategy. Alice may change the market probabilities however she wants in the ﬁrst stage. where Alice plays in the ﬁrst and third stages and Bob plays in the second stage. Theorem 5 describes a PBE of the Alice-Bob-Alice game. Corollary 2 in Section 4 indicates that if myopic players follow predeﬁned sequence of play then on expectation a player is better off by playing second than ﬁrst in I games. bl ). The strategies and beliefs off the equilibrium path are straightforward. beliefs are consistent with strategies. Thus. Bob may change the probabilities in the second stage. rN = Pr(Y |ak . In the second stage. 6.1 Truthful Equilibrium of CI Games We study the PBE of the game when Alice and Bob have conditionally independent signals.

Pr(N |ak .Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 23 – Alice does nothing in the third stage. When cA = ai . When cA = ai+1 . µB ). the expected proﬁt that Alice gets from case 1 is the same as what she gets from the following sequence of actions: (a) Alice changes market probabilities to r1 that are different from her posteriors in the ﬁrst stage. Pr(Y |r . Bob’s belief µB gives 1 1 – If x1 ≤ rY ≤ xnA . where ai is the i-th element of CA . When Alice does not deviate: Alice changes market probabilities to her true posteriors Pr(Y |ak ). and Alice plays a best response according to Lemma 5 by changing market probabilities to Pr(Y |ak . cB . µB ) = x1 . cB . xi = Pr(Y |cA = ai ). Alice does nothing in the third stage. 1 – If cA = a1 and 0 ≤ y < x1 . When Alice changes market probability to r1 in the ﬁrst stage. Pr(N |ak ) in the ﬁrst stage. xnA as the vector of Alice’s possible posteriors for the outcome Y . with probability α change market 1 probability to rY = y and (1 − α) play truthful betting. We denote x = x1 . Pr(N |r1 . change market probability to rY = y. cB ). Without loss of generality. By Lemma 2. is exactly the payoff of moving from the starting point to the end point of the second move. cB ) in the second stage. Pr(Y |r1 . Consider the two cases: 1. 1 – If cA = anA and xnA < y ≤ 1. 1 1 – If 0 ≤ rY < x1 . report truthfully. µB ) in the second stage. change market probability to rY = y. We show that Alice does not want to deviate by changing market probabilities to r1 = Pr(Y |cA ). – For all other cases. Bob does not want to deviate from truthful betting in the second stage given that Alice truthfully reports her posteriors in the ﬁrst stage. The mixing probabilities α and β satisfy that Pr(Y |rY = y) = y. µB ) = xnA . Bob changes market probabilities to Pr(Y |r1 . assume that xi < xj iff i < j. 1 – If xnA < rY ≤ 1. Pr(N |ak ) . That is. The total payoff of two consecutive moves. Pr(Y |r1 . cB ). (b) A sequence selection game starts with initial market probabilities r1 .. 1 When observing a rY = y = xi for all 1 ≤ i ≤ nA . with 1 probability β change market probability to rY = y and (1 − β) play truthful 1 betting. Bob’s belief µB is consistent with Alice’s off-equlibrium mixed strategy: – If cA = ai or cA = ai+1 and xi < y < xi+1 ... Without loss of generality. Pr(N |ak . in a market using the LMSR. (c) Alice changes . Alice selects herself to be the ﬁrst player. mix between truthful betting 1 and reporting rY = y. When Alice deviates: Alice changes market probabilities to r1 that is different from Pr(Y |ak ). Pr(N |cA ) . cB ) in the third stage. 2. assume that Alice has signal cA = ak . Bob changes the probabilities to Pr(Y |ak . Proof Bob’s belief µB is similar to that of the sequence selection game as described in the proof for Theorem 3. Hence. We compare Alice’s expected proﬁts conditional on her signal in these two cases with the aid of the sequence selection game. µB ) = rY . .

Alice does not want to deviate from truthful betting. We deﬁne . Pr(N |r1 . cB ) . (d) Bob changes market probabilities to Pr(Y |ak . According to Theorem 1. market probabilities to Pr(Y |ak ).1: change market probability to r1 = Pr(Y |cA = ak ).2 Nonexistence of Truthful Equilibrium in I Games We study the equilibrium of the game when Alice and Bob have independent signals and the general informativeness condition holds. where π (σ) is Bob’s expected myopic optimal proﬁt following a ﬁrst round strategy σ as deﬁned in Section 4.24 Y. cB . A natural question to ask. Similarly. (c’)Bob changes market probabilities to Pr(Y |r1 . 6. and (d) is greater than or equal to that from (b’). However. Alice’s expected proﬁt from (b). Theorem 6 says that there are not when players have informative and distinct signals. 0 rz which is ﬁxed given r0 and the joint probability distribution P. µB ) . truthful betting is the only WPBE of the game. Pr(N |ak ) . π B (σ) ≥ π B (σ T ) and the equality holds only when σ = σ T . the truthful betting PBE is the unique WPBE of the 3stage Alice-Bob-Alice game. Pr(N |ak . and (d’). Then. the total expected proﬁt of Alice and Bob from the game is π AB = k. because Alice can simply deviate to the truthful strategy and get higher expected proﬁt. we show that the truthful strategy in this setting is not a WPBE. The truthful strategy for Alice is the same as that in Section 6. Proof According to Lemma 5. at a WPBE the market probability in the third stage always reveals information of both Alice and Bob. Hence. (b’) A sequence selection game starts with initial market probabilities r1 . after we know that Alice being truthful is a PBE. (d’) Alice changes market probabilities to Pr(Y |ak . Alice has an incentive to deviate from the truthful strategy on her ﬁrst trade in the market. Pr(N |cA = ak ) in the ﬁrst stage. cB = bl . Thus. for any WPBE A strategy σ of Alice.z Pr(cA = ak . Alice’s expected proﬁt from (a) is the same as that from (a’). In particular. cB = bl ) . (c). Let σ be AlA ice’s strategy at a WPBE. Theorem 6 When Alice and Bob have conditionally independent signals that are informative and distinct. cB . Pr(N |ak . µB ). Alice selects Bob to be the ﬁrst player. cB ). the expected proﬁt that Alice gets from case 2 is the same as what she gets from the following sequence of actions: (a’) Alice changes market probabilities to r1 that are different from her posteriors in the ﬁrst stage. cB ) . Chen et al. any strategy σ such that πσ < π AB − π B (σ T ) can not be a WPBE strategy. with equality holds T A only when σ = σ . is whether there are other equilibria with Alice blufﬁng in the ﬁrst stage. Hence. Alice’s expected proﬁt by following σ is πσ = AB B B π − π (σ). cB ). But according to Theorem 3. (c’). at the equilibrium πσ ≤ π AB − π B (σ T ). ω = z) log Pr(ω = z|cA = ak .l. Thus.

Alice’s ﬁrst trade is a move from r1 to ˜1 . where ak = ak is another signal in CA . ˜ ˜ ˜ Since the total payoff of two consecutive moves in LMSR is exactly the payoff of moving from the starting point to the end point of the second move. a Pr(Y |ak ) Pr(N |ak ) As Bob has a probability of Pr(bl |ak ) of seeing bl as his signal. her expected change in proﬁt over following the truthful strategy. Theorem 7 If players have independent signals that satisfy the general informativeness condition. the expected score of Alice’s second trade in the market is: – » Pr(N |ak . bl ) Pr(Y |˜k . and bluffs. bl ) to r3 = a a Pr(Y |ak . and reacts accordingly. Therefore. Proof For conciseness. bl ) Pr(Y |ak .bl ) ) a = D(p(ω|ak ) ||p(ω|˜k ) ) a . we use Pr(ak ) to represent Pr(cA = ak ) and similarly for other terms. we eliminate the r0 to r1 move in our comparison analysis and treat the myopic move as if it had zero expected proﬁt and analyze the blufﬁng strategy as a move from r1 to ˜1 . bl ). by the deﬁnition of LMSR r her expected score from the ﬁrst move is: Pr(Y |ak ) log Pr(N |˜k ) a Pr(Y |˜k ) a + Pr(N |ak ) log = −D(p(ω|ak ) ||p(ω|˜k ) ). bl ) Pr(bl |ak ) Pr(Y |ak . If Alice observes her signal. Due to the overlap in r the expected score in the truthful strategy and the blufﬁng strategy for Alice. We have l Pr(bl |ak )D(p(ω|ak . Alice’s total expected payoff conditional on her signal is the sum of the above two expressions.bl ) ||p(ω|˜k . Below we show that the expected proﬁt change of deviating from the truthful strategy is greater than zero.bl ) || l Pr(bl |ak )p(ω|˜k . is ∆= l Pr(cB = bl |cA = ak )D(p(ω|ak . which gives ∆ in our theorem. Pr(N |cA = ak ) . bl ) a Pr(N |˜k . r Lemma 6 Assume that Bob expects Alice to play truthfully. Pr(N |˜k .bl ) ) a X l Thus.bl ) ) a l ≥ D( Pr(bl |ak )p(ω|ak . bl ) log + Pr(N |ak . Alice will move the market from r2 = Pr(Y |˜k .Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 25 the blufﬁng strategy for Alice as: change market probability to ˜1 = Pr(Y |cA = r ak ).bl ) ||p(ω|˜k . bl ) a lX = Pr(bl |ak )D(p(ω|ak . truthful betting is not a WPBE for the Alice-Bob-Alice game.bl ) ) − D(p(ω|ak ) ||p(ω|˜k ) ). we may now consider a blufﬁng strategy by Alice during the ﬁrst trade as a move from r0 to r1 immediately followed by a move from r1 to ˜1 . bl ) with probability Pr(bl |ak ).bl ) ||p(ω|˜k . thus Alice has an incentive to deviate from the truthful strategy. cA = ak . a a where p(ω|·) denotes the probability distribution of ω conditional on signal realizations. bl ). Proof Lemma 6 gives the expected proﬁt change of Alice if she were to deviate from truthful betting. Pr(N |ak .

we can compute Alice’s expected proﬁt for playing TB.2. Theorem 8 Consider the Alice-Bob-Alice LMSR coin-ﬂipping game. Truthful betting is not a WPBE strategy. if he has heads. 1 (10) If Bob has tails he sets the probability of HH to zero. and otherwise play H. Similarly. Chen et al. (12) . (HT|TH|TT)}. In our model.TH. and the law of total probability. The equality follows from the independence of the two signals. We again consider an Alice-Bob-Alice game structure.1 Explicit Blufﬁng Equilibria in a Restricted Game We now introduce a simple model of independent signals and show that blufﬁng can be an equilibrium. Bob’s best response is. Assuming such a strategy for Bob. for each outcome in {HH. her proﬁt for moving the probability from p0 to p or 0. The inequality follows from the convexity of relative entropy [11]. Thus. Alice and Bob each see an independent coin ﬂip and then participate in a LMSR prediction market with outcomes corresponding to whether or not both coins came up heads. 6. ω ∈ {HH. Alice’s expected proﬁt for always pretending to have heads in the ﬁrst stage is: p2 log p p0 + log 1 x 1−p + p(1 − p) log 1−p0 + (1 − p)p log 1−p 1−p0 + log 1−0 1−x + (1 − p)2 log 1−p 1−p0 . A WPBE in this game has Alice p ˆ play TB with probability t = 1 + 1−(1−p)−1/p (1−p) . plus her proﬁt for moving the probability to 0 or 1 from where Bob moves it. ( ) Proof To show that playing TB with probability t is an equilibrium. Now restrict Alice’s ﬁrst stage strategies to either play ˆ truthful betting (TB) or as if her coin is heads (H). We note that by the general informativeness condition the inequality is strict. We have p2 log p p0 + log 1 x + (1 − p)2 log 1−p + p(1 − p) log 1−p0 + (1 − p)p log 1−0 1−p0 1−0 1−p0 (11) where x is Bob’s posterior probability when he has heads and Alice appears to have heads. This is done by computing. we ﬁrst compute Bob’s best response to such a strategy and then show that Bob’s strategy makes Alice indifferent between her pure strategies. ∆ > 0.TT}. to set the probability of HH to the probability that Alice has heads given ˆ that she bets as if she does (we denote Alice betting as if she had heads as H): ˆ Pr(HH | HH) = ˆ Pr(HH | HH) Pr(HH) ˆ ˆ Pr(HH | HH) Pr(HH) + Pr(HH | TH) Pr(TH) 2 1·p = 1 · p2 + (1 − t)(1 − p)p = 1 − (1 − p) p . Pr(bl |ak ) = Pr(bl ).HT. Therefore. where the probability of heads is p.26 Y.

it is a PBE at which any player reports truthfully at its ﬁrst chance to play. there is a blufﬁng WPBE. Suppose the contrary. Alice is indifferent between truthfulness and blufﬁng when Bob expects her to play TB with probability t. We can combine the signals of those players standing in between as one signal and treat those players as one composite player. The game from stage t to stage t becomes an Alice-Bob-Alice game. Proof Given that every player believes that all players before it act truthfully. Inferring recursively.1 Truthful Equilibrium of CI games We ﬁrst consider the CI setting where players have conditionally independent signals. 7 Finite-Player Finite-Stage Game We extend our results for the Alice-Bob-Alice game to games with a ﬁnite number of players and ﬁnite stages in LMSR. pretend to have seen heads regardless of her actual information. and does not play in stages between t and t . suppose the player is Alice and she bluffs at some stage t.Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 27 Since (11) and (12) are equal when x is set according to (10). If signals are informative and distinct. Alice blufﬁng at stage t contradicts with the uniqueness of the WPBE of the Alice-Bob-Alice game. Select the last player who bluffs in the sequence. The following theorem characterizes the PBE of the game. at a PBE of the game all players report their posterior probabilities in their ﬁrst round of play. the truthful betting PBE is the unique WPBE of the game. 7. . Theorem 6 states that the truthful betting PBE is the unique WPBE of the Alice-Bob-Alice game. it will truthfully report its posterior probabilities by Lemma 2. with 1 − t probability. Because signals are conditionally independent. we prove the theorem recursively using backward induction. ﬁnite-stage game with LMSR. Alice must play truthfully at some stage t > t + 1. Then. If signals are informative and distinct. Alice should. there are other players standing in between its second to last chance to play and its last chance to play. Combining signals of players between t and t as one composite signal. Each player can change the market probabilities multiple times and all changes happen in sequence. This implies that truthful betting PBE is also a unique WPBE for the ﬁnite-player ﬁnite-stage game. If it’s player i’s last chance to play. The game becomes an Alice-Bob-Alice game for player i and at a PBE player i reports truthfully at its second to last chance to play according to Theorem 5. that is. if players have conditionally independent signals. Theorem 9 In the ﬁnite-player. If it’s player i’s second to last chance to play. It is therefore in equilibrium for Alice to play TB with probability t. the signal of the composite player is conditionally independent of the signal of player i. Without loss of generality.

Proof If there are m players. for example Alice.2 No Truthful Equilibrium in I Games For the I setting where players have independent signals. Hence. Proof Consider the last two trades of a player who plays more than once. Because signals are independent. the result for ﬁnite-player ﬁnite-stage game directly follow from our result on the Alice-Bob-Alice game. If signals are informative and distinct. suppose the last time for a player to bluff is in stage i. 8 Finite-Player Inﬁnite-Stage Games In this section. truthful betting is not a WPBE strategy. Chen et al. we know that Alice is better off by blufﬁng at stage t. Knowing that other players are playing truthfully. as is shown in the following theorem. If t and t > t + 1 are the last two stages for Alice to trade and all other players play truthfully. According to Theorem 5 player i would prefer to report truthfully. 7. at a ﬁnite PBE all players truthfully report their posterior probabilities at their ﬁrst chance of play. The game from stage t to stage t can be viewed as an Alice-Bob-Alice game. ﬁnite-stage game with LMSR. if players have independent signals that satisfy the general informativeness condition. we analyze a model in which the number of potential moves can be inﬁnite. A player may decide to have one more trade at any time before the market closes. truthful betting reveals all information after m stages.28 Y. a player who plays in stage i < m does not want to deviate to blufﬁng in stage i and come to trade again in stage m + 1. and there is at least one player who trades more than once. By Theorem 7. If there exists a ﬁnite equilibrium that reveals all information at stage t. truthful betting is not a WPBE. Theorem 10 In the ﬁnite-player. because the game between stages i and m + 1 can be viewed as an Alice-Bob-Alice game. 8. This is motivated by the observation that there is often no pre-deﬁned last stage for a player. Alice’s signal is independent of the composite signal. the truthful betting equilibrium is the unique ﬁnite WPBE of the game.1 Truthful Betting Equilibrium in CI Games Games with conditionally independent signals remain to have a unique equilibrium. Theorem 11 In a potentially inﬁnite-stage game with conditionally independent signals. We extend our results for ﬁnite-stage games to inﬁnite-stage games and examine the equilibrium for CI and I settings respectively. we can combine signals of all players who trade between t and t as a composite signal possessed by a composite agent. truthful betting PBE. then it must report truthfully in some .

9.5. Alice and Bob without loss of generality. There is not ﬁnite equilibrium. perhaps resulting in an incentive to play the truthful strategy. They play in stages t − 1 and t respectively.3. Then.2 Nonexistence of Finite Equilibrium in I Games Theorem 12 In an inﬁnite-stage game with independent signals that satisfy the general informativeness condition. Proof For contradiction.2 and introduce the concepts of complementarity and substitution of signals in Section 9. it has an incentive to not fully divulge this information when it may play multiple times in the market. a player will always have some private information revealed by its signal. If signals are informative and distinct. according to Theorem 6. when players have independent signals. We propose a discounted logarithmic market scoring rule and show that the I games can converge to full information aggregation exponentially. 8.2. Then. we propose the discounted LMSR market.1. We ﬁrst introduce the discounted LMSR mechanism in Section 9.1 Discounted LMSR One way to address the incentives that traders with independent signals have to bluff in a market using the logarithmic market scoring rule is to reduce future payoffs using a discount parameter. Based on this intuition. The general informativeness condition guarantees that no matter what the signal distribution is. Because the WPBE reveals all information. Intuitively if a player has some private information that may be revealed by its signal. according to Theorem 7. both Alice and Bob reports truthfully at stages t − 1 and t. and 9.4.4. there is no WPBE that reveals all information after ﬁnite number of trades. Consider the last two players. Truthful betting is the only ﬁnite equilibrium.3. Alice would want to deviate to bluff in stage t − 1 and play again in stage t + 1. Facilitated with results in Sections 9. Thus. 9 Discounted LMSR and Entropy Reduction For inﬁnite-stage games. truthful betting equilibrium is the only WPBE of the Alice-Bob-Alice game. σ can not be a WPBE strategy proﬁle. We present a natural metric to quantify degree of information aggregation in Section 9. we characterize the inﬁnite-stage games as continuation games in Section 9. consider any WPBE strategy proﬁle σ that always results in the optimal market prediction after some number t of stages in a potentially inﬁnite-stage game. the market can not fully aggregate information of all players with ﬁnite trades. The game between stages i and j can be viewed as an Alice-Bob-Alice game. we present our convergence analysis for discounted LMSR in Section 9. . 9.Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 29 stage j and i + 1 < j ≤ t. Contradiction arises.

1 and 8. In other words.2 For simplicity. Let δ ∈ (0. The δ-discounted market scoring rule is a market microstructure in which traders update the predicted probability of the event under consideration just as they would in the regular market scoring rule. for an Alice-Bob-Alice CI game in the discounted LMSR. we assume that there are only two players. However. 1) be a discount parameter. however. The trader would then be given a payoff of δ i−1 (log q − log p).1 can show that truthful betting is the unique WPBE for ﬁnite-stage and inﬁnite-stage CI games with ﬁnite players in the discounted LMSR. for example. we only focus on I games in the discounted LMSR. we will show that. truthful betting is still the unique WPBE in the discounted LMSR. the market price will converge towards the optimal probability for the particular realized set of information signals. 9. 2 . with Alice being the ﬁrst player. Suppose a trader moves the prediction for outcome Y from p to q in the i-th stage of the market. On the other hand. We note that for CI games. Alice and Bob. from now on. We will show that the discounted LMSR can have better non-myopic strategic properties for I games. We do not. Chen et al. it does surely happen in the long run at any WPBE. This decomposition is possible in equilibrium analysis. because the actual ﬁrststage strategy σ1 is common knowledge in an equilibrium proﬁle. although complete aggregation of information may not happen in two rounds. we assume a strict alternating sequence of trades between Alice and Bob. They alternately play in the market. and the outcome Y is later observed to happen. the same arguments in Sections 7. the value (positive or negative) of trade is discounted over time.2 Continuation Games It is useful to think about an inﬁnite-stage market game G as a ﬁrst-stage move followed by a subsequent game H that perhaps depends on the ﬁrst-stage move. Alice does not want to deviate from the truthful betting strategy as in the non-discounted LMSR because for any deviating strategy her expected proﬁt in the ﬁrst stage is the same in both the non-discounted LMSR and the discounted LMSR but her expected proﬁt in the third stage in the discounted LMSR is strictly less than that in the non-discounted LMSR. the myopic strategic properties of the market scoring rule are retained in the discounted form. The regular market scoring rule corresponds to δ = 1. we are proposing a mechanism that explicitly discounts gains and losses in later rounds. if the outcome Y did not happen. Intuitively. in any WPBE strategy proﬁle σ. As truthful betting is the unique WPBE in an Alice-Bob-Alice CI game in the discounted LMSR. For simplicity. Thus. the beliefs of the players after observing the ﬁrst move x are consistent with private signals It is possible that traders intrinsically discount future proﬁts. Then. and the trader moves the prediction from p to q in the i-th stage the trader would earn a payoff of δ i−1 (log(1 − q) − log(1 − p)).30 Y. assume any intrinsic discounting by traders. Clearly. rather. making deviation even more undesirable. they may be uncertain about how long their information will remain private. Even though that the discounted LMSR may admit equilibria in which players bluff with some probability.

.Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 31 and a common prior p that depends on the initial prior p0 . the prior p in H is consistent with p0 . . Proof We need to show that if Hi → Hi+1 . We denote this G → H. suppose that x is one of the points that the ﬁrst player in Hi plays with positive probability according to σ. ω = z} = Pi {c1 = k. . Observe that if G → H. We deﬁne G → G to always be true. ∗ we write G → H and say G reduces to H if there is a sequence G = ∗ H0 . Let Pi {c1 = k|x. the continuation game Hi+1 has joint probability distribution Pi+1 such that Pi+1 {c1 = k. ∗ We deﬁne the relation → as the reﬂexive transitive closure of →. Deﬁnition 3 We say that H is a continuation game of G if there is a ﬁrst-stage strategy σ1 and a move x such that x is played with nonzero probability under σ. ω = z|c1 = k} Pi {c1 = k|x. c2 = l. b) are the same in G and H. Only the prior over different signals changes after a ﬁrst-round strategy. i. Without loss of generality. player 2 updates its beliefs after seeing x. ω = z|x. and x. Hi+1 satisﬁes the same independence property as Hi . – If G satisﬁes the independence (I) property. signal realization of player 2. then. and the sequence of play in H is the same as the subsequence of play in G after the ﬁrst move in G. Then. ω = z} Pi {c1 = k|σ} where k. cB = b) for any given pair of signal realizations (a. and realized outcome respectively. Then. so does H. l. Hk = H such that Hi → Hi+1 for all i. We use Pi {·} to represent probability of some outcome under Pi . σ} = Pi {c1 = k. σ} be the probability that player 1 has signal k conditional on that it plays x. Lemma 7 shows that continuation games preserve the independence property of the original game.e. .. the full-information optimal probabilities Pr(Y |cA = a. σ} ∗ ∗ = Pi {c1 = k|x. the ﬁrst-stage strategy σ1 and the observed move x. not the full-information posterior probabilities. so does H. c2 = l. Let σ be a WPBE strategy for game Hi . σ1 . H1 . and z represent signal realization of player 1. σ}Pi {c2 = l. – If G satisﬁes the conditional independence (CI) property. Lemma 7 Suppose G → H. c2 = l. H2 . Let Pi be the joint probability distribution for Hi . knowing player 1 follows σ. .

Pi+1 {c2 = l|ω = z} = = = Pi {c1 =k|x. c2 = l|ω = z} = Pi+1 {c1 = k|ω = z}Pi+1 {c2 = l|ω = z}. ω = z} = l|ω = z} Pi+1 {ω = z} Pi {c1 =k|x. Pi+1 {c1 = k. c2 = l. Pi+1 {c1 = k. σ} = Pi {c1 = k|σ}Pi {c2 = l} Pi {c1 = k|σ} = Pi {c1 = k|x.σ} k Pi {c1 =k|σ} Pi {c1 = k. c2 = l. σ} = Pi {c1 = k.σ} k Pi {c1 =k|σ} Pi {c1 Thus. Pi+1 of game Hi+1 also satisﬁes I condition. c2 Pi+1 {ω = z}/Pi {ω = z} Pi {c1 =k|x.σ} Pi {c1 =k|σ} Pi {c1 = k|ω = z}Pi {c2 Pi {c1 =k|x. ω = z} Pi {c1 = k|σ} Pi {c1 = k|x.σ} Pi {c1 =k|σ} Pi {c1 = k. c2 = l. σ} Pi {c1 = k. Pi+1 {ω = z}/Pi {ω = z} Pi {c1 =k|x.σ} Pi {c1 =k|σ} Pi {c1 = k. σ}Pi {c2 = l} . Pi+1 {c1 = k. c2 = l. c2 = l|ω = z} = Pi+1 {ω = z} = = = Pi {c1 =k|x.σ} k Pi {c1 =k|σ} Pi {c1 = k.σ} Pi {c1 =k|σ} Pi {c1 = l|ω = z} Pi+1 {ω = z}/Pi {ω = z} = k. We ﬁrst show that if Pi of game Hi satisﬁes CI condition. c2 = l} Pi {c1 = k|σ} Pi {c1 = k|x.σ} Pi {c1 =k|σ} Pi {c1 = k|ω Pi+1 {ω = z}/Pi {ω = z} = z} . Pi+1 of game Hi+1 also satisﬁes CI condition. c2 = l|ω = Pi {c1 =k|x. Pi+1 {c1 = k|ω = z} = = Pi+1 {ω = z} Pi {c1 =k|x. ω = z} = k.σ} k Pi {c1 =k|σ} Pi {c1 = k. Chen et al. c2 = l} = = ω ω Pi+1 {c1 = k. ω = z} Pi {c1 = k|x. ω = z} = z} . We then show that if Pi of game Hi satisﬁes I condition. we also have = Pi {c2 = l|ω = z}. c2 = l. ω = z} Pi+1 {c1 = k.32 Y. ω = z}/Pi {ω CI condition holds for Hi+1 . c2 = l|ω = z} z} = z} Pi+1 {ω Pi {c1 =k|x.

Pi {c1 = k|x.e.. We also have Pi+1 {c1 = k} = = l l Pi+1 {c1 = k. If signals are substitutes.3 Complementarity or Substitution of Signals In this section. 9.Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 33 The second to the last equality is because of the independence condition of Hi . Pi+1 {c1 = k. the expected proﬁt from knowing both signals is greater than the sum of the expected proﬁts from knowing only the individual signals. i. σ} Pi {c1 = k. if signals of Alice and Bob are complements. For a game G participated by Alice and Bob. In other words. σ} Pi {c1 = k. c2 = l} Pi {c1 = k|σ} = l = Pi {c1 = k|x. Hi+1 satisﬁes independence. Deﬁnition 4 The complementarity coefﬁcient C(G) of a market game G is deﬁned as π A (σ N ) + π B (σ N ) C(G) = . π AB = π B (σ N ) + π A (σ T ) = H(ω|cA . and Alice moves ﬁrst. π AB is the sum of Alice’s and Bob’s expected proﬁt if they both follow the truthful strategy. cB ). ∗ By induction. c2 = l} Pi {c1 = k|σ} = k = Pi {c2 = l}. we introduce the concept of complementarity for signals. σ} and Pi+1 {c2 = l} = = k Pi {c1 = k|x. π AB . σ} Pi {c1 = k|σ}Pi {c2 = l} Pi {c1 = k|σ} k Pi+1 {c1 = k. then H preserves the same independence property as G. σ} Pi {c1 = k|σ}Pi {c2 = l} Pi {c1 = k|σ} Hence. the order of play is not important. if G → H. c2 = l} Pi {c1 = k|x. Intuitively. the total proﬁt potential in G is π AB = π A (σ N ) + π B (σ T ). c2 = l} = Pi+1 {c1 = k}Pi+1 {c2 = l}. the relation is reversed. c2 = l} Pi {c1 = k|x. We note that under either the CI condition or the I condition. Now we deﬁne the complementarity coefﬁcient of a game that captures the complementarity of players’ signals.

π A (σ N ) + π B (σ N ) > π A (σ N ) + π B (σ T ) = π AB ⇒ C(G) > 1. any game G that starts with the prior probability ˆ satisﬁes C(G) < 1. and the associated ex-ante . ˆ ˆ ˆ By deﬁnition of C. where the right-hand side proﬁts are implicitly a function of the game G under consideration. Thus. Lemma 8 Under the CI model. σ). If C(G) > 1.34 Y.4 Proﬁt Potential and Entropy We now present a natural metric. Lemma 9 Under the I model. ∗ 9. Thus. that quantiﬁes the degree of aggregation in a prediction market after i trades under strategy proﬁle σ: Di is the expectation. π A (σ N ) + π B (σ N ) < π A (σ N ) + π B (σ T ) = π AB ⇒ C(G) < 1. an information node φ consists of a realization of the signals of the two players and a sequence of t trades in the market. Formally. and thus. By lemma 7. ˆ The complementarity bound Cσ (G) is the minimum value of C(H) over all games H that G could reduce to by following the strategy proﬁle σ: ˆ Cσ (G) = H:G→H by σ min ∗ C(H) We note that if C(G) < 1. Chen et al. we must have Cσ (G) > 1 for any σ. and denote p∗ (φ) = p∗ (φ). it follows that π B (σ N ) > π B (σ T ) for any CI game G with informative and distinct signals. for a strategy proﬁle σ and a number of stages t. Let p∗ (φ) = Pr(Y |realization of signals in φ). and thus we must have Cσ (G) < 1. Proof From Theorem 2. Thus. and denote pi (φ) = pi (φ). The aggregative effect of the strategy proﬁle σ after i trades is summarized by the collection of information nodes φ that can be reached. 1 − p∗ (φ) . Proof From Theorem 1. the information deﬁcit Di . we know that any H such that G → H itself satisﬁes the CI condition ˆ no matter what strategy the reduction follows. it follows that π B (σ T ) > π B (σ N ) for any I game G starting with the prior probability. Cσ (G) < 1. of the relative entropy between the optimal probability (given the realization of the signals) and the actual probability after i stages. 1 − pi (φ) . any game G with informative and distinct signals ˆ satisﬁes Cσ (G) > 1 for any strategy proﬁle σ. signals are substitutes. Let pi (φ) = Pr(Y |ﬁrst i trades in φ. we have Cσ (G) ≤ C(G). over all possible signal realizations and the randomization of moves as dictated by σ. signals are complements. the market probability pi (φ) in stage i.

k∈Z+ ˜ M i = D1 − D2 + δ(D3 − D4 ) + . we can now deﬁne M i as the expected proﬁt of the i-th trade in the discounted LMSR. in addition to measuring the distance from full information aggregation. i. Di is always nonnegative. ˜ Given the deﬁnition of M i . with positive probability. We now show that. because the relative entropy is always nonnegative.e. φ:φ∈σ When t = 0. The key result is that Di can be related to the expected payoff of the i-th stage move in the non-discounted (standard) LMSR: Lemma 10 Let M i denote the expected proﬁt (over all signal nodes φi ) of the i-th trade under proﬁle σ.. . Then. we deﬁne Di (σ) = Eσ [D(p∗ (φ)||pi (φ))] = Pr(φ)D(p∗ (φ)||pi (φ)) . the information nodes φ correspond to different realizations of the signals. If Di > 0. ˜ Mi = δ k (D2k − D2k+1 ) ∀i = 2k + 1 δ k (D2k+1 − D2(k+1) ) ∀i = 2k + 2 (13) ˜ Using the deﬁnition of M i we write the total proﬁt for Alice in the δdiscounted LMSR as: Alice’s payoff = i:i=2k. . If Di = 0. Now for i ≤ t. . Di also enables interesting strategic analysis. We can similarly rewrite Bob’s expected payoff as: Bob’s payoff = i:i=2k. . the market has not yet reached the optimal probability. it implies that the market will always have reached its optimal probability for the realized signals by the i-th stages. We assume discounting after every even trade. it indicates that.k∈Z+ ˜ M i−1 = D0 − D1 + δ(D2 − D3 ) + .Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 35 probability Pr(φ) of reaching each such information node. . Note that D0 is the same as π AB deﬁned in the previous section. after every trade by Bob. M i = Di−1 − Di Proof 1 − pi (φ) pi (φ) + (1 − p∗ (φ)) log pi−1 (φ) 1 − pi−1 (φ) Mi = φ:φ∈σ Pr(φ) p∗ (φ) log = φ:φ∈σ Pr(φ) D(p∗ ||pi−1 ) − D(p∗ ||pi ) = Di−1 − Di The ﬁrst equality holds by the deﬁnition of M i and the second by the deﬁnition of relative entropy. This suggests another interpretation for Di : Di represents the expected value of the potential proﬁt left for trades after the i-th trade.

We exclude such degenerate cases. because if not. C(G). for I games that start with the prior probability. Recall that after stage 2. This argument generalizes to any even number of rounds. In the ﬁrst stage. Bob will revise his beliefs consistent with the proﬁle σ and the realized action x. Now. Without loss of generality we assume that Bob moves second in the market. and a particular instance of the two-person market game induced by the δ-discounted LMSR. a simple deviation to the truthful strategy would be beneﬁcial. Alice will take some (perhaps mixed) action x dictated by σ. the stability of a given strategy proﬁle σ may change with δ. Note that D0 = π AB . we bound the value of Dn for large n. the total expected payoff of Bob in equilibrium is also at least π B (σ N ). We will express our convergence bound in terms of complementarity coefﬁcient. we could have lack of information aggregation even with the myopic strategy. ﬁx a discount parameter δ. by looking at the total expected proﬁts within the ﬁrst 2k moves. Of course. Therefore we can bound D2 as: D2 ≤ D0 − [π A (σ N ) + π B (σ N ) − δD2 ]. and thus.36 Y. the myopic strategy may not involve any movement by either player. 9. We also know that the total expected payoff of Alice in equilibrium is at least π A (σ N ). Let σ be any WPBE of this market game. we can rewrite inequality (15) D2k ≤ ˆ D0 (1 − Cσ (G)) 1 − δk (16) . Because π B (σ) ≥ π B (σ N ). the total expected payoff of both players is at most δD2 . and assume that C(G) > 0. and the remaining proﬁt potential δ k D2k : ⇐⇒ (1 − δ )D2k ≤ D0 − [π A (σ N ) + π B (σ N )] π A (σ N ) + π B (σ N ) = D0 1 − D0 0 D (1 − C(G)) ⇐⇒ D2k ≤ 1 − δk k D2k ≤ D0 − [π A (σ N ) + π B (σ N ) − δ k D2k ] (14) (15) as: ˆ Note that. According to Theorem 2. Chen et al. by deﬁnition. Note that if C(G) = 0. We reiterate that the deﬁnition of Di is not dependent on δ. Thus. This means that the total payoff of the ﬁrst two rounds in the market is at least π A (σ N ) + π B (σ N ) − δD2 . C(G) ≥ Cσ (G). Under the equilibrium strategy proﬁle σ. in any WPBE. It is a measure of the informational distance between the prices after i trades in proﬁle σ and the optimal prices. we have π B (σ) ≥ π B (σ N ).5 Asymptotic Convergence in Discounted LMSR for I Games In this part.

for both ﬁnite-stage and inﬁnite-stage games. Now consider the remainder of the game after 2k rounds.Gaming Prediction Markets: Equilibrium Strategies with a Market Maker 37 From inequality (16) we see that the bound on D2k depends only on δ. Then. Hence. for any game G with independent signal. then G → H2k . We show that traders with conditionally independent signals may be worse off by blufﬁng in LMSR. To summarize. as ˆ D and Cσ (G) are both constants for any instance of the market and equilibrium proﬁle σ. . we examine different scenarios where traders at equilibrium bet truthfully or bluff. Speciﬁcally. are considered. inequality (17) shows that ˆ 4 log Cσ the relative entropy of the probabilities with respect to the optimal probabilities reduces exponentially over time. we rewrite inequality (16) in terms of δ and for a round n = 2km. ˆ ˆ We set k such that δ k/2 = Cσ (G). ˆσ (G)) ˆ Cσ (G) < 1. Using this value of k and a log δ n value m = 2k we note that: 0 Dn ≤ D0 = D0 = D0 (1 + δ ) n ˆ = D0 (1 + Cσ (G))− 2k − n log δ ˆ ˆ = D0 (1 + Cσ (G)) 4 log Cσ (G) = D0 δ ˆ n ˆ − log(1+Cσ (G)) ˆ 4 log Cσ (G) m ˆ 1−Cσ (G) 1−δ k ˆ 1−Cσ (G) (1−δ k/2 )(1+δ k/2 ) k/2 −m m (17) σ (G)) Note that − log(1+C(G) depends only on the complementarity bound of ˆ 4 log Cσ the game. for all n > 1. etc. the equilibrium proﬁle σ will also induce an equilibrium proﬁle on H2k . According to Lemma 7. We can repeat the argument to bound D4k in terms of D2k .e. For this game. − log(1+C(G) > 0. the information deﬁcit Dn after n rounds of trading is bounded by Dn ≤ D0 δ n ˆ − log(1+Cσ (G)) ˆ 4 log Cσ (G) 10 Conclusion We have investigated the strategic behavior of traders in LMSR prediction markets using dynamic games with incomplete information. H2k preserves the independence property of G. denoted as ∗ H2k . Hence. with a δ-discounted logarithmic market scoring rule. truthful betting is not only a PBE strategy but also a unique WPBE strategy for all traders in LMSR. let σ be any WPBE strategy proﬁle. we have proven the following result: Theorem 13 Let G be a market game in the I model. In this way. Two different information structures. k = 2 log Cσ (G) . i. According to Lemma 9. Moreover. conditional independence and unconditional independence of signals. Both ﬁnite-stage and inﬁnite-stage games are investigated. Therefore.

C. A. to ameliorate this potential problem. Nelson. Gale. B. 2008. They might engage in blufﬁng strategies to bargain over how this subsidy is divided. Healy and Mohammad Mahdian for helpful discussions. A. 2009. We use a simple modiﬁcation to the market scoring rule. as measured by the relative entropy between full information aggregation and the actual market probability. E. When are signals complements or o a substitutes? Working paper. which includes a form of discounting. Allen and D. Can asset markets be manipulated? A ﬁeld experiment with race-track betting. Prediction markets as decision support systems. We thank anonymous reviewers for their valuable comments. J. References 1. Kulick. Roust. Handbook of Experimental Economics Results. For inﬁnite-stage games with unconditionally independent signals. North Holland. Berg and T. We are grateful to Paul J. Information Systems Frontier. This allows us to prove a bound on the rate at which the error of the market. Chen et al. Plott. Stock-price manipulation. A. Berg. A. players can pool their information together to make sharper predictions than either could alone and thus extract an even larger proﬁt. Results from a dozen years of election futures markets research. A. 6. Journal of Political Economy. F. Explicit discounting can make this bargaining more efﬁcient. 1992. S. 1998. Journal of Economic Behavior and Organization. B¨ rgers. 2003. T. In C. editors. The exponent depends on the complementarity coefﬁcient of the market instance. when the signals of traders are unconditionally independent. there does not exist any WPBE that fully reveals information of all players in ﬁnite stages. Amsterdam. Rietz. Smith. (106):457–482. Acknowledgments Stanko Dimitrov was supported by NSF grants CCF-0728768 and IGERT0114368. Forsythe. Rahul Sami was partially supported by NSF grant CCF-0728768. On the other hand. B. Camerer. Axelrod. The Review of Financial Studies. Kr¨ hmer. Design improved parimutueltype information aggregation mechanisms: Inaccuracies and the long-shot bias as disequilibrium phenomena. and T. 3. 5. E. truthful betting is not a WPBE for ﬁnite-stage games. J. reduces exponentially over time. Traders have incentives to strategically mislead other traders with the intent of correcting the errors made by others in a later stage. C. J. . R. 69:170–181. (5):503–529. Hernando-Veciana. 5:79–93. D.38 Y. 4. F. 2. The need for discounting shows a connection to classical bargaining settings in which players bargain over how to divide a surplus they can jointly create. Rietz. and K. Moreover. In a prediction market. and D. We provide a blufﬁng equilibrium for a restricted twoplayer game. 2007. We thank John Ledyard for pointing us to earlier work on discounting in parimutuel markets. F. informed players can extract a proﬁt from the market. Plott and V. R.

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