Price Experimentation and Security Market Structure

Chris J. Leach and Ananth Madhavan

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: This paper examines the role of market makers in facilitating price discovery. We show that a specialist may experiment with prices to induce more informative order flow, thereby expediting price discovery. Market makers in a multiple dealer system, unlike a specialist system, do not have the incentives to perform such costly experiments because of free-rider problems. Consequently, the specialist system may provide open markets where competition fails, but at the cost of wider bid-ask spreads. We analyze the effect of experimentation on the bid-ask spread and provide an exploratory analysis of intraday specialist data which is consistent with our price experimentation hypothesis

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Journal Article: Price Experimentation and Security Market Structure (1993)
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