Information Exchange in Prediction Markets: Do Social Networks Promote Forecast Efficiency?

Abstract

This paper studies the effects of information transmission on wisdom of the crowd. We provide a game-theoretic framework to resolve the question: Do social networks promote the forecast efficiency in prediction markets? Our study shows that a social network is not a panacea in terms of improving forecast accuracy. The use of social networks could be detrimental to the forecast performance when the cost of information acquisition is high. We also study the effects of social networks on information acquisition in prediction markets. In the symmetric Bayes-Nash equilibrium, all participants use a threshold strategy, and the equilibrium information acquisition is decreasing in the number of participant's friends and increasing in the network density. The aforementioned results are robust to two commonly used mechanisms of prediction markets: a forecast-report mechanism and a security-trading mechanism.