Competitive Markets and Aggregate Information

A frequently asked question is, how informationally efficient are market prices? In answering this question, economists commonly model the price formation process as one of tâtonnement where agents revise their beliefs until a market-clearing price is established. The Walrasian market thus aggregates all relevant information about an asset and yields a strong-form efficient price. A second approach, consistent with the structure of some modern-day securities markets, is to utilize a competitive dealer framework where traders submit orders to market makers who compete for trades. Using the demand and supply orders from agents, market makers compile information by first aggregating demand and, second, by using it as a conditioning variable to determine future payoffs and price. This paper constrasts the Walrasian and competitive market structures. The motivation for this analysis is threefold: First, it is common for empiricists to assume rational expectations markets in forming their hypotheses, even for markets such as the NASDAQ, which are clearly not Walrasian. It is important to know that this assumption does not adversely affect the validity of empirical results. Second, economists sometimes employ the notion of the rational expectations equilibrium. By contrasting the two market structures, it is possible to infer that prices formulated in markets are indeed rational, and empirical studies that use market data have the underlying assumption of rationality. Third, the analysis shows that ag-gregating information is a double-edged sword because on one hand it leads to informative prices, but simultaneously, markets can aggregate information so well that there is no incentive to obtain information in the first place (consistent with Grossman [1976]), a result that implies market failure from an informational perspective. The results demonstrate that competing market makers aggregate information so that market participants have ex post homogeneous expectations and equilibrium price is strong-form efficient. Specifically, it is shown that a competitive dealer system mimics the behavior of a Walrasian rational expectations market when the idio-syncratic error components of private signals are identically and independently distributed , risk-averse agents trade to maximize expected utility of terminal wealth, and aggregate demand is equated to supply. These results are obtained from the simultaneous development of two equilibrium pricing models. For both economies, the market is defined as one with a single type of agent: informed traders receive private signals regarding the future value of a risky asset where the signal is the true value of the asset plus an idiosyncratic