How Do Prediction Market Fees Affect Prices and Participants?

The CFTC has recently licensed a commercial prediction market to operate in the US. Previous theoretical work has not incorporated that prediction markets charge fees. We examine the impact of fees by introducing them to a model in which the market price equals the true probability when there are no fees. We find that fees charged on winnings generally mean contract prices for low probability outcomes are below the true probability but the impact of fees means prediction markets feature a form of favorite-longshot bias: Post-fee loss rates depend negatively on the probability of the event being backed.