Optimal Liquidity Provision for Decision Makers
50 Pages Posted: 25 Mar 2008 Last revised: 30 Aug 2011
Date Written: December 2007
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: Suggested Citation