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Rev Fin 1993; 6:375-404
© 1993 the Society for Financial Studies

Article

Price experimentation and security market structure

JC Leach and AN Madhavan
Department of Finance, The Wharton School, The University of Pennsylvania, Philadelphia, PA 19104, USA

Abstract

We examine 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 that is consistent with our price experimentation hypothesis.


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