Information, Asset Price Volatility, and Liquidity

How are asset price volatility and liquidity impacted by public perception of the economic state and by market competitivity? We wish to understand the direct impacts as well as indirect impacts via information acquisition and aggregation. To investigate, we design a laboratory experiment with human subjects as bond investors and exogenously vary the bond default rate, the private information cost schedule, and the market format. To discipline the experiment parameters and to obtain hypotheses for empirical testing, we construct a theoretical model that closely parallels the experiment. We find that the laboratory data support most theoretical predictions, for example, liquidity increases when traders purchase more precise private information, when public information indicates a less ominous state, and when the market is less competitive. Overall price volatility also increases with more precise private information and less competitivity, but it decreases with less ominous public information. Decomposing volatility into “efficient” and “inefficient” components may offer insight for policy analysis. This paper was accepted by Dorothea Kübler, behavioral economics and decision analysis. Funding: This work was supported by University of California Santa Cruz. Supplemental Material: The online appendices and data files are available at https://doi.org/10.1287/mnsc.2024.04911 .