Chapter 39 Quiz: Ethics of Prediction Markets

Test your understanding of the ethical concepts, frameworks, and practical considerations discussed in this chapter.

Question 1

What is the primary ethical concern associated with prediction markets on harmful events?

a) They are too difficult to implement technically b) They create financial incentives for participants to cause the harmful events c) They always produce inaccurate price signals d) They violate antitrust laws in most jurisdictions

Answer: b) Moral hazard in prediction markets refers to the creation of financial incentives to cause harmful events. When a market pays out upon the occurrence of a bad event, participants who can influence the outcome have a financial motive to make it happen.

Question 2

In the moral hazard condition formula $V_{\text{profit}} \cdot P_{\text{success}} > C_{\text{cause}} + P_{\text{caught}} \cdot \text{Penalty}$, which strategy directly reduces $V_{\text{profit}}$?

a) Increasing law enforcement surveillance b) Implementing position limits c) Requiring identity verification d) Delaying market settlement

Answer: b) Position limits cap the maximum number of contracts a participant can hold, directly reducing the maximum potential profit ($V_{\text{profit}}$) from causing an event.

Question 3

Which of the following is an example of a "conditional market design" intended to reduce moral hazard?

a) A market on "Will Building X be attacked?" b) A market on "Given that a major attack occurs, which sector will be targeted?" c) A market on "When will the next terrorist attack happen?" d) A market on "How many people will die in the next attack?"

Answer: b) Conditional market design phrases the question as conditional on an event already occurring, so the market does not create a marginal incentive to cause the triggering event. The market aggregates information about the nature of threats rather than incentivizing new threats.

Question 4

What is the "dignity argument" against prediction markets on sensitive topics?

a) Markets on sensitive topics always lose money b) Some things should not be treated as commodities regardless of information value c) Sensitive topics cannot be accurately predicted by markets d) Regulators will always shut down sensitive markets

Answer: b) The dignity argument, associated with philosopher Michael Sandel's critique of market reasoning, holds that certain goods are corrupted by their commodification. Treating human death or suffering as tradeable commodities violates the inherent dignity of the persons involved, regardless of the information value the market might provide.

Question 5

Which type of market manipulation involves placing large orders with the intent to cancel them before execution?

a) Wash trading b) Spoofing c) Front-running d) Pump and dump

Answer: b) Spoofing involves placing and then cancelling large orders to create a false impression of supply or demand. The manipulator never intends for the orders to be filled; they are designed to influence other traders' behavior.

Question 6

In the context of prediction markets, what makes self-fulfilling prophecies ethically distinct from manipulation?

a) Self-fulfilling prophecies are always illegal while manipulation is legal b) Self-fulfilling prophecies may emerge from genuine information aggregation, while manipulation involves intentional deception c) Self-fulfilling prophecies only occur in commodity markets d) There is no ethical distinction; they are the same thing

Answer: b) Self-fulfilling prophecies can emerge organically from the interaction between market prices and real-world behavior (e.g., a bank run predicted by a market). This is distinct from manipulation, which involves intentional deception. However, the causal feedback loop raises ethical concerns about the power of prediction markets to shape reality.

Question 7

The equilibrium price in a prediction market approximates a wealth-weighted average of beliefs. If wealthy participants systematically have different beliefs from lower-income participants, this means:

a) The market price will always be more accurate b) The market price will always be less accurate c) The market price may reflect the biases of the wealthy rather than the aggregate wisdom of all participants d) The market price will not be affected by wealth distribution

Answer: c) When wealth is correlated with particular biases or perspectives, the market price inherits those biases because wealthier participants can take larger positions. The market price reflects a wealth-weighted, not equal-weighted, average of beliefs.

Question 8

What is the primary argument FOR allowing insider trading in prediction markets (as opposed to stock markets)?

a) Insiders deserve to profit from their knowledge b) Insider trading improves information aggregation, which is the core purpose of prediction markets c) Insider trading is impossible to detect in prediction markets d) Prediction market regulators do not have jurisdiction over insider trading

Answer: b) Unlike stock markets where insider trading undermines fair access, the core purpose of prediction markets is information aggregation. If insiders trade, their private information is incorporated into prices more quickly, improving the accuracy of the market signal for all users.

Question 9

Which of the following distinguishes prediction market trading from pure gambling (like roulette)?

a) Prediction markets never involve financial risk b) Prediction markets reward research and calibrated probability assessment c) Prediction markets always have positive expected value for all participants d) Prediction markets do not involve uncertain outcomes

Answer: b) While prediction market trading shares characteristics with gambling (uncertain outcomes, financial stakes, intermittent reinforcement), it differs in having a genuine skill component. Traders who do better research and maintain better probability calibration tend to outperform, unlike in pure games of chance.

Question 10

A self-exclusion program for prediction market traders should be designed so that:

a) Users can opt in and opt out at any time without restrictions b) Exclusion is easy to activate but difficult to reverse, with a cooling-off period c) Exclusion is mandatory for all users after a certain loss threshold d) Exclusion permanently bans users from the platform with no possibility of return

Answer: b) Effective self-exclusion programs are designed to be easy to activate (reducing barriers when a user recognizes they have a problem) but difficult to reverse (preventing impulsive reversal during vulnerable moments). A cooling-off period provides time for the user to reconsider.

Question 11

From a utilitarian perspective, prediction markets are ethically justified when:

a) They always produce accurate forecasts b) The total welfare benefits (better decisions, information discovery) outweigh the costs (gambling harm, moral hazard, manipulation) c) A majority of participants profit d) They comply with all existing regulations

Answer: b) Utilitarianism evaluates prediction markets by their consequences for overall welfare. The ethical calculation weighs benefits (improved decisions, information aggregation, entertainment) against costs (gambling harm, moral hazard realization, manipulation-induced errors, distributional inequality).

Question 12

Kant's second formulation of the categorical imperative is most directly violated by:

a) A prediction market on aggregate economic indicators b) A prediction market on the death of a specific named individual c) A play-money prediction market on election outcomes d) A prediction market on weather events

Answer: b) Kant's second formulation requires treating persons as ends in themselves, never merely as means. A market on the death of a specific named individual treats that person as an instrument for traders' financial purposes, violating their dignity as an end in themselves.

Question 13

In a Rawlsian analysis, prediction markets would most likely be endorsed under what conditions?

a) No conditions; prediction markets are inherently unjust b) Only if real-money markets are banned entirely c) With broad access provisions, gambling protections, restrictions on morally hazardous markets, and redistribution of information benefits d) Only if they are operated exclusively by governments

Answer: c) Rawls's difference principle requires that social institutions benefit the worst-off. Prediction markets can satisfy this condition if proper safeguards ensure broad access, protect vulnerable populations, restrict the most dangerous markets, and distribute the benefits of better information broadly.

Question 14

Which virtue does prediction market trading MOST directly cultivate?

a) Temperance (moderation) b) Intellectual humility (well-calibrated confidence) c) Generosity (sharing wealth) d) Compassion (empathy for others)

Answer: b) Prediction markets penalize overconfidence and reward well-calibrated probability estimates. Traders who assign appropriate uncertainty to their beliefs tend to outperform, directly cultivating the virtue of intellectual humility.

Question 15

What is the key ethical distinction between "passive insiders" and "active insiders" in prediction market ethics?

a) Passive insiders trade more frequently b) Active insiders can influence the outcome of the event they trade on c) Passive insiders always lose money d) Active insiders are always identified by the platform

Answer: b) The ethical concern with insider trading in prediction markets is not primarily about information asymmetry (which can improve market accuracy) but about the combination of information with the ability to influence outcomes. Active insiders who can both predict and cause events pose moral hazard risks that passive insiders do not.

Question 16

Which of the following is NOT a recommended privacy-by-design principle for prediction market platforms?

a) Tiered disclosure for different stakeholders b) Publishing all user trading records publicly c) Encryption of data at rest and in transit d) Data retention limits

Answer: b) Publishing all user trading records publicly would violate privacy principles. Privacy-by-design recommends tiered disclosure (different levels of detail for different stakeholders), not blanket public disclosure of all user data.

Question 17

The cost of manipulation in a well-functioning prediction market is modeled as $C = \int_{p_0}^{p_{\text{target}}} L(p) \, dp$. This implies that manipulation is more expensive when:

a) The market has less liquidity b) The market has more liquidity (deeper order book) c) Fewer participants are active d) The market has no automated market maker

Answer: b) The integral of liquidity over the price range represents the total cost of absorbing all available orders between the current price and the target price. Higher liquidity means more orders must be absorbed, increasing the cost of manipulation. This is why deep, liquid markets are more resistant to manipulation.

Question 18

A prediction market on pandemic death tolls is ethically MORE defensible than a prediction market on a specific individual's death because:

a) Pandemic markets are always more profitable b) Aggregate markets reduce moral hazard and commodification concerns compared to individual-targeted markets c) Pandemic markets are easier to manipulate d) Individual death markets are more accurate

Answer: b) Aggregate markets (pandemic death tolls) are less ethically problematic because: (1) no single actor can plausibly cause a pandemic to profit from the market (reduced moral hazard), and (2) the market does not reduce a specific person to a commodity (reduced dignity violation). The information value argument is also stronger for public health purposes.

Question 19

If a prediction market uses quadratic pricing where the cost of $n$ shares is $n^2 \cdot c$, what is the primary equity benefit?

a) It makes all shares free b) It prevents anyone from trading c) It limits the influence of wealthy participants by making large positions disproportionately expensive d) It increases the accuracy of the market price

Answer: c) Quadratic pricing means that doubling your position quadruples the cost, making it progressively more expensive to accumulate large positions. This limits the ability of wealthy traders to dominate the market signal, giving smaller participants proportionally more influence.

Question 20

Which of the following best describes the "social value argument" for prediction markets?

a) Prediction markets always make society better off with no downsides b) Prediction markets improve decision-making through better forecasting, but this social value is conditional on proper design and safeguards c) Prediction markets have no social value beyond entertainment d) The social value of prediction markets has been definitively proven by academic research

Answer: b) The social value argument holds that prediction markets can improve decisions, save lives through better forecasting, and enhance accountability. However, these benefits are conditional on sufficient liquidity, actual use of the market signal by decision-makers, resistance to manipulation, adequate moral hazard mitigation, responsible gambling features, and broad access.

Question 21

A trader notices that two accounts are trading almost exclusively with each other, with high reciprocity (A buys from B, then B buys from A, repeatedly). This pattern is most consistent with:

a) Informed trading b) Wash trading c) Statistical arbitrage d) Momentum trading

Answer: b) High reciprocity between two accounts (trading back and forth with each other) is a classic indicator of wash trading — artificial trading designed to inflate volume without genuine transfer of risk or information.

Question 22

From a virtue ethics perspective, a trader who regularly trades on events involving human suffering and becomes desensitized to that suffering is exhibiting:

a) Intellectual humility b) Epistemic rigor c) Callousness (a vice) d) Courage

Answer: c) Virtue ethics is concerned with character development. A trader who becomes desensitized to suffering through regular trading on tragic events is developing the vice of callousness — a failure of empathy that, regardless of its effect on trading performance, represents a deterioration of moral character.

Question 23

The difference principle in Rawlsian ethics states that:

a) All social goods should be distributed equally b) Social institutions are just if they benefit the worst-off members of society c) The majority's preferences should always prevail d) Economic efficiency is the only relevant criterion

Answer: b) Rawls's difference principle states that inequalities in social institutions are justified only if they benefit the least advantaged members of society. Applied to prediction markets, this means the institution is just if even those who are worst-off (e.g., non-participants who benefit from better public policy) are better off than they would be without prediction markets.

Question 24

Which of the following is the BEST example of a delayed settlement strategy for reducing moral hazard?

a) Paying out market contracts immediately upon event occurrence b) Requiring a 30-day investigation period between event occurrence and market settlement, during which positions of anyone involved in causing the event can be voided c) Never settling markets at all d) Settling markets before the event occurs based on current price

Answer: b) Delayed settlement creates a window for investigation. If authorities determine that a market participant was involved in causing the event, their positions can be voided, eliminating the financial incentive. This deters moral hazard without eliminating the market's information value.

Question 25

A comprehensive approach to prediction market ethics requires:

a) Applying only utilitarian analysis, since consequences are all that matter b) Applying only deontological analysis, since rights are inviolable c) Drawing on multiple ethical frameworks (utilitarian, deontological, virtue ethics, contractarian) and accepting that reasonable people may disagree d) Avoiding ethical analysis entirely and relying on market forces

Answer: c) No single ethical framework provides complete answers to prediction market ethics questions. Each framework illuminates different aspects: utilitarianism focuses on consequences, deontology on rights and duties, virtue ethics on character, and contractarianism on fairness. Responsible ethical analysis draws on all of these and acknowledges that ethical trade-offs often involve genuine disagreement among reasonable people.