Survey_Kyle_1985

Abstract

" In this section we motivate our equilibrium concept by discussing a simple model of one-shot trading. This model is not quite a game theoretic one because the market makers do not explicitly maximize any particular objective. We could, however, replace the market efficiency condition in step two with an explicit Bertrand auction between at least two risk neutral bidders, each of whom observes the ""order flow"" i + u-and nothing else. The result of this explicit auction procedure would be our market efficiency condition, in which profits of market makers are driven to zero. Modelling how market makers can earn the positive frictional profits necessary to attract them into the business of market making is an interesting topic which takes us away from our main objective of studying how price formation is influenced by the optimizing behavior of an insider in a somewhat idealized setting. Kyle [5], however, discusses a model of imperfect competition among market makers, in which many insiders with different information participate. The insider exploits his monopoly power by taking into account the effect the quantity he chooses to trade in step one is expected to have on the price established in step two. In doing so, he takes the rule market makers use to set prices in step two as given. He is not allowed to influence this rule by committing to a particular strategy in step one: The quantity he trades is required to be optimal, given his information set at the time it is chosen. This requirement seems to be reasonable given anonymous trading and the strong incentives informed traders have to cheat given any other strategy they commit to. The insider is not allowed to condition the quantity he trades on price. A model in which insiders choose demand functions (""limit orders"") instead of quantities (""market orders"") is considered in Kyle. "