A standard presumption of market microstructure models is that competition between risk-neutral market makers inevitably leads to price schedules that leave market makers zero expected profits conditional on the order flow. This article documents an important lack of robustness of this zero-profit result. In particular, we show that if traders can split orders between market makers, then market makers set less-competitive price schedules that earn them strictly positive profits and hence raise trading costs. Thus, this article can explain why somebody might willingly make a market for a stock when there are fixed costs to doing so. The analysis extends to a limit order book, which by its nature is split against incoming market orders: equilibrium limit order schedules necessarily yield those agents positive expected profits.

A standard presumption of market microstructure models is that competition between risk-neutral market makers inevitably leads to price schedules that leave market makers zero expected profits conditional on the order flow. This article documents an important lack of robustness of this zero-profit result. In particular, we show that if traders can split orders between market makers, then market makers set less-competitive price schedules that earn them strictly positive profits and hence raise trading costs. Thus, this article can explain why somebody might willingly make a market for a stock when there are fixed costs to doing so. The analysis extends to a limit order book, which by its nature is split against incoming market orders: equilibrium limit order schedules necessarily yield those agents positive expected profits.

[We study insider trading in a dynamic setting. Rational, but uninformed, traders choose between investment projects with different levels of insider trading. Insider trading distorts investment toward assets with less private information. However, when investment is sufficiently information elastic, insider trading can be welfare-enhancing because of more informative prices. When insiders repeatedly receive information, they trade to reveal it when investment is information elastic because good news increases investment and hence future insider profits. Thus, more information is revealed and uninformed agents are exploited less frequently by insiders. Both effects are Pareto-improving. Finally, we consider various insider-trading regulations.]

We study insider trading in a dynamic setting. Rational, but uninformed, traders choose between investment projects with different levels of insider trading. Insider trading distorts investment toward assets with less private information. However, when investment is sufficiently information elastic, insider trading can be welfare-enhancing because of more informative prices. When insiders repeatedly receive information, they trade to reveal it when investment is information elastic because good news increases investment and hence future insider profits. Thus, more information is revealed and uninformed agents are exploited less frequently by insiders. Both effects are Pareto-improving. Finally, we consider various insider-trading regulations.

This paper investigates how noisy evaluation of worker skills affects human capital investments and hiring. Individuals distort investments toward skills that most managers can evaluate. Dynamically, when workers become managers, managerial expertise can become increasingly skewed over time, raising investment distortions and reducing output. If firms select managerial expertise strategically, efficient investments can be retrieved when (a) identifying whether workers' skills matter more than distinguishing among skilled workers, and (b) initial investment distortions are small. Otherwise, such strategic design worsens long-run outcomes. Finally, we determine when short-run affirmative action policies are effective.

The television game show The Price Is Right is used as a laboratory to conduct a preference-free test of rational decision theory in an environment with substantial economic incentives. It is found that contestants' strategies are transparently suboptimal. In response to this evidence, simple rules of thumb are developed that are shown to explain observed bidding patterns better than rational decision theory. Further, learning during the show reduces the frequency of strategic errors. This is interpreted as evidence of bounded rationality. Finally, there is no evidence that a concern for fairness significantly alters bidding behavior. Copyright 1996 by American Economic Association.

The television game show The Price Is Right is used as a laboratory to conduct a preference-free test of rational decision theory in an environment with substantial economic incentives. It is found that contestants' strategies are transparently suboptimal. In response to this evidence, simple rules of thumb are developed which are shown to explain observed bidding patterns better than rational decision theory. Further, learning during the show reduces the frequency of strategic errors. This is interpreted as evidence of bounded rationality. Finally, there is no evidence that a concern for fairness significantly alters bidding behavior.

We argue that competition between dealers in a classic dealer market is intertemporal: A trader identifies a particular dealer and negotiates a final price with only the intertemporal threat to switch dealers imposing pricing discipline on the dealer. In this kind of market structure, we show that dealers will offer greater price improvement to more regular customers, and, in turn, these customers optimally choose to submit larger orders. Hence, price improvement and trade size should be negatively correlated in a dealer market. We confirm our model's predictions using unique data from the London Stock Exchange during 1991. Copyright 2005, Oxford University Press.

We argue that competition between dealers in a classic dealer market is intertemporal: A trader identifies a particular dealer and negotiates a final price with only the intertemporal threat to switch dealers imposing pricing discipline on the dealer. In this kind of market structure, we show that dealers will offer greater price improvement to more regular customers, and, in turn, these customers optimally choose to submit larger orders. Hence, price improvement and trade size should be negatively correlated in a dealer market. We confirm our model's predictions using unique data from the London Stock Exchange during 1991.

We characterize optimal mutual fund risk-taking strategies in competitive multi-period tournaments among multiple players. With multiple competitors, every player begins by taking maximum risk. In the final period, all players continue to take maximum risk except the leading player, who employs a “lock-in” strategy that depends on the magnitude of the lead. Our theory predicts the leader should strategically lock in advantage by reducing risk-taking if and only if the lead is great enough, rather than an increase in risk-taking by the trailers to try to catch up. Empirical evidence from style-adjusted mutual fund tournaments provides strong and robust support.