[We examine the role of market makers in facilitating price discovery. We show that a specialist may experiment with prices to induce more informative order flow, thereby expediting price discovery. Market makers in a multiple-dealer system, unlike a specialist system, do not have the incentives to perform such costly experiments because of free-rider problems. Consequently, the specialist system may provide open markets where competition fails but at the cost of wider bid-ask spreads. We analyze the effect of experimentation on the bid-ask spread and provide an exploratory analysis of intraday specialist data that is consistent with our price experimentation hypothesis.]

This paper demonstrates that market makers have the ability and incentive to facilitate price discovery in securities markets. Market makers can expedite the process of intertemporal price formation by setting prices to induce statistically more informative order flow. Such actions constitute an investment in the production of information. Under certain conditions, market makers can recoup the cost of this investment by making better pricing decisions in the future with more precise information. These conditions are analyzed in a general model and several examples that illustrate the complex nature of price discovery are presented.

We examine the role of market makers in facilitating price discovery. We show that a specialist may experiment with prices to induce more informative order flow. thereby expediting price discovery. Market makers in a multiple-dealer system, unlike a specialist system, do not have the incentives to perform such costly experiments because of free-rider problems. Consequently, the specialist system may provide open markets where competition fails but at the cost of wider bid-ask spreads. We analyze the effect of experimentation on the bid-ask spread and provide an exploratory analysis of intraday specialist data that is consistent with our price experimentation hypothesis.

Ananth N. Madhavan, Robert T. Masson, William H. Lesser, Cooperation for Monopolization? An Empirical Analysis of Cartelization, The Review of Economics and Statistics, Vol. 76, No. 1 (Feb., 1994), pp. 161-175