Rational Mispricing and Irrational Mispricing in Betting Markets: Implications for Market Effi ciency Tests∗

Testing market effi ciency in betting markets does not necessarily get around the joint hypothesis problem because the result depends on the assumed role of bookmakers. In a simple model of monopolistic competition, bookmakers’ rational pricing induces the Favorite-Longshot Bias even without bettors’irrationality (Rational Mispricing) and accommodates bettors’irrational beliefs to exploit betting demands (Irrational Mispricing). In European football betting markets, we find significant evidence for both Rational Mispricing and Irrational Mispricing. The former mispricing, though much larger than the latter, depends on bookmakers’market power and may have little to do with financial market ineffi ciency. The latter mispricing, albeit smaller, suggests that bettors overstate the persistence of team performance (Hot-Hand Bias), which may explain the reversal in betting returns and asset returns. Increased competition among bookmakers has not weakened the biases, which is diffi cult to explain only by bettors’irrationality but consistent with the predicted pricing behavior of bookmakers.