Aggregation of Information and Beliefs in Prediction Markets∗

We propose a simple model of prediction markets in which traders with heterogeneous prior beliefs and private information are allowed to risk a limited amount of money. For any given information realization, the equilibrium price can be interpreted as a posterior belief given a representative market prior belief. However, across information realizations, we show that this market prior belief is a decreasing function of the likelihood ratio of the private information possessed by the traders. Thus, the market price underreacts to information, consistent with the favoritelongshot bias. Underreaction results more generally under the realistic assumption that traders have decreasing absolute risk aversion.