Optimal Liquidity Provision for Decision Makers

50 Pages Posted: 25 Mar 2008 Last revised: 30 Aug 2011

See all articles by Paul C. Tetlock

Paul C. Tetlock

Columbia Business School - Finance

Robert W. Hahn

Technology Policy Institute; University of Oxford, Smith School

Date Written: December 2007

Abstract

Although prices in financial markets play an important role in improving allocative efficiency in the real economy, few models of securities markets explicitly incorporate resource allocation decisions. In this paper, we study the equilibrium in a securities market when the market price provides valuable information that can improve allocative efficiency. We show that a decision maker will subsidize liquidity in an illiquid securities market to gather valuable information about her decision payoffs. We also show that a decision maker's liquidity subsidy improves expected social welfare by enhancing allocative efficiency, but does not induce the socially optimal level of information acquisition. Finally, we demonstrate that the mere act of linking the allocation decision to the market price will typically enhance liquidity in the securities market. Overall, our results highlight the potential of using securities markets for information to improve public and private decisions.

Keywords: Liquidity, Prediction Markets, Information Markets, Subsidy

JEL Classification: D81, G14

Suggested Citation

Tetlock, Paul C. and Hahn, Robert W., Optimal Liquidity Provision for Decision Makers (December 2007). AEI-Brookings Joint Center Working Paper No. 06-18, Available at SSRN: https://ssrn.com/abstract=891741 or http://dx.doi.org/10.2139/ssrn.891741

Paul C. Tetlock (Contact Author)

Columbia Business School - Finance ( email )

3022 Broadway
New York, NY 10027
United States

HOME PAGE: http://www0.gsb.columbia.edu/faculty/ptetlock/

Robert W. Hahn

Technology Policy Institute ( email )

1401 Eye St. NW
Suite 505
Washington, DC 20005
United States

University of Oxford, Smith School ( email )

Oxford
United Kingdom

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