Information and Learning in Markets:
The Impact of Market Microstructure
Xavier Vives
The ways financial analysts, traders, and other specialists use information and learn from each other are of fundamental importance to understanding how markets work and prices are set. This graduate-level textbook analyzes how markets aggregate information and examines the impacts of specific market arrangements--or microstructure--on the aggregation process and overall performance of financial markets. Xavier Vives bridges the gap between the two primary views of markets--informational efficiency and herding--and uses a coherent game-theoretic framework to bring together the latest results from the rational expectations and herding literatures.
Vives emphasizes the consequences of market interaction and social learning for informational and economic efficiency. He looks closely at information aggregation mechanisms, progressing from simple to complex environments: from static to dynamic models; from competitive to strategic agents; and from simple market strategies such as noncontingent orders or quantities to complex ones like price contingent orders or demand schedules. Vives finds that contending theories like informational efficiency and herding build on the same principles of Bayesian decision making and that "irrational" agents are not needed to explain herding behavior, booms, and crashes. As this book shows, the microstructure of a market is the crucial factor in the informational efficiency of prices.

• Provides the most complete analysis of the ways markets aggregate information
• Bridges the gap between the rational expectations and herding literatures
• Includes exercises with solutions
• Serves both as a graduate textbook and a resource for researchers, including financial analysts

Xavier Vives is professor of economics and finance at IESE Business School in Barcelona. He is the author of Oligopoly Pricing: Old Ideas and New Tools.
Review:
"[R]eading Professor Vives's prose was a joy. His explanations for why various results obtain are clear and the flow from model to model is natural. Results in later chapters are frequently related to results in earlier chapters, tying the whole book together. . . . [I]t is an excellent reference."--Lawrence R. Glosten, Journal of Economic Literature
Endorsements:
"When and how well do markets aggregate information spread among rational participants? Xavier Vives offers the first unified treatment of all major answers, some from his own recent research, to these important questions. Relying on elementary methods and linear-quadratic models, he succeeds in conveying even to the nonspecialist reader the essence of the most sophisticated results."--Bernard Lebrun, York University
"Thoughtful and persuasive. The book is ambitious in its scope. It will be a reference for PhD-level courses in microeconomics, financial economics, and some parts of industrial organization. This is an important book."--Hyun Song Shin, Princeton University

TABLE OF CONTENTS:
Preface xi Introduction and Lecture Guide 1 References 12
Chapter 1: Aggregation of Information in Simple Market Mechanisms: Large Markets 15
1.1 Introduction and Overview 15
1.2 Large Cournot Markets 17
1.3 Welfare in Large Cournot Markets with Asymmetric Information 27
1.4 Information Aggregation in Smooth Large Markets 29
1.5 Auctions and Voting 38
1.6 Endogenous Information Acquisition 40
1.7 Summary 45
1.8 Appendix 46
1.9 Exercises 48
References 51

Chapter 2: Aggregation of Information in Simple Market Mechanisms: How
Large Is Large? 53
2.1 A General Linear-Normal Cournot Model 54
2.2 Convergence to Price Taking in a Cournot Market 57
2.3 Endogenous Information Acquisition 58
2.4 Convergence to the First-Best: Market Power and Information Aggregation 62
2.5 Convergence in Auctions 67
2.6 Summary 70
2.7 Appendix 71
2.8 Exercises 74
References 76

Chapter 3: Rational Expectations and Supply Function Competition 78
3.1 Rational Expectations Equilibrium: Concepts, Problems, and Welfare 78
3.2 Supply Function Competition and REE in a Continuum Economy 84
3.3 Welfare Analysis of REE 95
3.4 Strategic Supply Function Equilibria and Convergence to a Price-Taking Equilibrium 98
3.5 Double Auctions 100
3.6 Summary 102
3.7 Appendix 102
3.8 Exercises 103
References 105

Chapter 4: Rational Expectations and Market Microstructure in Financial Markets 107
4.1 Market Microstructure 108
4.2 Competitive Rational Expectations Equilibria 112
4.3 Informed Traders Move First and Face Risk-Neutral Competitive Market Makers 130
4.4 Hedgers and Producers in a Futures Market 135
4.5 Summary 145
4.6 Appendix 147
4.7 Exercises 148
References 152

Chapter 5: Strategic Traders in Financial Markets 156
5.1 Competition in Demand Schedules 157
5.2 Informed Traders Move First 168
5.3 Market Makers Move First 177
5.4 An Application: Welfare Analysis of Insider Trading 183
5.5 Summary 189
5.6 Exercises 190
References 195

Chapter 6: Learning from Others and Herding 199
6.1 Herding, Informational Cascades, and Social Learning 200
6.2 Extensions of the Herding Model 204
6.3 A Smooth and Noisy Model of Learning from Others 210
6.4 Applications and Examples 222
6.5 The Information Externality and Welfare 227
6.6 Rational Expectations, Herding, and Information Externalities 236
6.7 Summary 239
6.8 Appendix 240
6.9 Exercises 241
References 244

Chapter 7: Dynamic Information Aggregation 248
7.1 Rational Expectations, Full-Information Equilibria, and Learning 248
7.2 Learning and Convergence to a Full-Information Equilibrium with Uninformed Firms 253
7.3 Market Dynamics with Asymmetric Information 257
7.4 Slow Learning and Convergence 261
7.5 Summary 266
7.6 Appendix 267
7.7 Exercises 271
References 273

Chapter 8: Dynamic Rational Expectations Models in Competitive Financial Markets 276
8.1 Dynamic Competitive Rational Expectations 277
8.2 The Impact of Risk-Averse Market Makers 285
8.3 Dynamic Trading with Short-Term Investors 294
8.4 Explaining Crises and Market Crashes 306
8.5 Summary 318
8.6 Appendix 320
8.7 Exercises 324
References 326

Chapter 9: Price and Information Dynamics in Financial Markets 330
9.1 Sequential Trading, Dynamic Market-Order Markets, and the Speed of Learning from Past Prices 331
9.2 Strategic Trading with Long-Lived Information 339
9.3 Market Manipulation and Price Discovery 347
9.4 Strategic Trading with Short-Lived Information 355
9.5 Strategic Hedging 358
9.6 Summary 360
9.7 Appendix 361
9.8 Exercises 362
References 365

Chapter 10: Technical Appendix 369
10.1 Information Structures and Bayesian Inference 369
10.2 Normal Distributions and Affine Information Structure 375
10.3 Convergence Concepts and Results 383
10.4 Games and Bayesian Equilibrium 390
References 398

Index 401
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