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Market Selection, Frictions, and the Information Content of Prices

Periodic Reporting for period 3 - INFORMATIVEPRICES (Market Selection, Frictions, and the Information Content of Prices)

Reporting period: 2019-05-01 to 2020-10-31

An important reason to trust markets arises from the belief that market prices accurately summarize the vast array of information held by market participants. Whether this belief is justified, that is, whether prices efficiently aggregate information dispersed among market participants is a central economic question. Prices provide incentives which guide production, investment and consumption decisions. In turn, these decisions determine the allocation of resources. Thus, asset or factor prices that accurately reflect preferences and beliefs are integral for economic efficiency. Unsurprisingly, there is a large body of research that explores the circumstances under which prices efficiently aggregate disperse information pertaining to beliefs and studies policies that lead to prices that are more responsive to information.

Informative prices require an informationally efficient price formation mechanism. In this project, we study the informational efficiency of price formation mechanisms using a large common-value auction framework. This framework is chosen to address the following questions: (1) How do market frictions affect information aggregation in an environment where bidders can strategically choose between markets? (2) What are the mechanisms through which market imperfections disrupt the information efficiency of prices? (3) Which market’s price is a better statistic for market participants’ information? (4) Which market attracts better informed bidders and therefore impounds new information into prices, i.e. where does market price discovery occur? (5) Do prices aggregate beliefs more accurately in good times or in bad? (6) Which market statistics, beyond price, contain information?

Informative prices also require informed market participants. However, reliable information is rarely free. Economic agents can acquire information either through investment in information or through communication with other informed agents. In this project, we also study which institutional structures provide incentives that allow for acquisition and truthful communication of information. We study information acquisition in a large auction model and we study communication in a repeated cheap-talk model. Our work on costly information acquisition outlines conditions on the costs and benefits of the information structure that allow for information aggregation. Our work on repeated communication outlines conditions under which an informed principal can communicate pertinent information to an agent whose preferences are not fully aligned with the principal.
Work performed on this project has produced three working papers so far. The summary of the papers are given below.

“Market Selection and the Information Content of Price” joint work with Mehmet Ekmekci

In this paper, we study price formation in a large, common-value auction where the value of the objects for sale depends on an unknown state of the world. Buyers choose, based on their private information, between bidding in the auction and an outside option, and therefore the distribution of bidders participating in the auction is determined endogenously in equilibrium. This framework allows us to highlight the interplay between self-selection into an auction, bidding behavior in the auction, and the information content of prices.

We first focus on an exogenous outside option that delivers a state-contingent payoff that is positive in at least one state. If the expected value of the outside option is nonnegative, then information is not aggregated in the auction in any equilibrium. We then turn to a model where bidders choose to participate in one of two concurrently operating auction markets. The outside option for one auction is the equilibrium value of participating in the alternative auction, i.e. outside options are endogenously determined. If frictions lead to uncertain gains from trade in the first auction, then information is not aggregated in either market even if the second auction is frictionless. This is because the two auction markets serve as state-contingent outside options for each other. Our findings are driven by how bidders self- select across options: A large disparity in the state-contingent payoffs in the two auctions implies that optimistic bidders select the option with a higher variance of state-contingent payoffs while pessimistic bidders select the option with a lower variance. Our results suggest a novel mechanism through which market imperfections in one market can have widespread effects across all linked markets. Moreover, our findings suggest that institutional differences are key for generating outside options that can hinder information aggregation.

This paper is in the third round of revisions for Econometrica.

“Starting Small to Communicate” joint work with Levent Kockesen and Elif Kubilay

In this paper, we study whether an informed principal can truthfully communicate with a uninformed agent acting on behalf of the principal. The principal and agent’s incentives are not aligned. We analyze a repeated cheap-talk game in which the receiver is privately informed about the conflict of interest between herself and the sender and either the sender or the receiver controls the stakes involved in their relationship. We focus on payoff-dominant equilibria that satisfy a Markovian property and show that if the potential conflict of interest is large, then the stakes increase over time, i.e. “starting small” is the unique equilibrium arrangement. In each period, the receiver plays the sender's ideal action with positive probability and the sender provides full information as long as he has always observed his ideal actions in the past. We also show that as the potential conflict of interest increases, the extent to which the stakes are back-loaded increases, i.e. stakes are initially smaller but grow faster. This paper has been published in Games and Economic Behavior.

“Price Discovery in a Large Auction with Costly Information” joint work with Mehmet Ekmekci

We study a common-value auction in which a large number of identical, indivisible object are sold to a large number of ex-ante identical bidders with unit demand. Before the auction, potential bidders can choose to buy information from a variety of sources at a cost. We derive the limit price distribution as a function of the set of available information sources. This allows us to quantify the information content of price and provide necessary and sufficient conditions for information aggregation.
Previous research shows that frictionless competitive markets, and in particular large auction markets efficiently aggregate information. However, less is known about how much information prices contain in frictional markets. How do market frictions affect the information content of prices? How does the information content of price depend on the structure of the market? Which institution provide better incentives for market participants to invest in information? Which institutional arrangements better facilitate the sharing of information? We anticipate that the results of this project will provide insights into these important economics questions.