Ulric B. and Evelyn L. Bray Social Sciences Seminar

Abstract: Common valuations pose an obstacle to trade and thus an existential threat to brokers, who profit from taxing trade. We write down a model in which a broker drives a wedge between valuations by deceiving gullible traders. Separate valuations facilitate arbitrage, and arbitrage generates brokerage fees. We then show that this scheme explains a classic case of market inefficiency: the favorite-longshot bias in horserace parimutuel markets. Racetracks induce naive bettors to overbet longshots by promulgating predictions that overestimate the chances of longshots. This creates arbitrage opportunities for sophisticated bettors and additional income for tracks. We document substantial cross-track variation in the extent of the favorite-longshot bias. Using original data, we show that this variation is predicted by the degree to which tracks overestimate the chances of longshots. Previous explanations for the favorite-longshot bias—i.e., speculation, probability weighting, and belief heterogeneity—can only explain cross-track variation in the bias with preferences or beliefs that vary idiosyncratically by track.