Informed Speculation with Imperfect

Competition
A. Kyle,The Review of Economic Studies, 1989

Andrea Gallo

School of Economics and Finance

Queen Mary University of London

Topics in Financial Economics A, 2020

Andrea Gallo Informed Speculation with Imperfect Competition

Introduction and Motivation
Information Asymmetry and Rational Expectations 1/2

In the ’80s one of the main focus in market microstructure

theory was information aggregation in markets with
asymmetric information

This motivated some famous competitive rational

expectations equilibrium models, like Grossman and
Stiglitz (1980) and Hellwig (1980)

Problem: these models requires agent to behave

schizophrenically (Hellwig): they are supposed to be price
takers, even though they actually influence prices with their
decisions

Andrea Gallo Informed Speculation with Imperfect Competition

Introduction and Motivation
Information Asymmetry and Rational Expectations 2/2

Possible solutions to the schizophrenia problem:

1 Assume that each trader is only one point in a continuum

of clones with the same private information

2 Large market in which each trader becomes small enough

(so no single pivotal trader!)

Andrea Gallo Informed Speculation with Imperfect Competition

Overview of the Model and of the Results
A Different Solution to the Schizophrenia Problem 1/2

Kyle proposes a different solution to modelling information

aggregation with asymmetrically informed traders

His key idea is that we can relax the assumption of perfect

competition in rational expectations model

In particular, he proposes a model of imperfect

competition in which informed speculator take into
account their influence on prices

Andrea Gallo Informed Speculation with Imperfect Competition

Overview of the Model and of the Results
A Different Solution to the Schizophrenia Problem 2/2

Convincing approach for two reasons:

1 In the real world, best informed traders are a big enough

share of the market and they are relevant in the final
allocation of goods and commodities (commodities futures,
auctions, stocks, mergers...)

2 Models based on perfect competition have some

unreasonable property. For example, with risk neutral price
taking agents, the equilibrium price reveals too much and
agents have no incentive to acquire information in the first
place!

Andrea Gallo Informed Speculation with Imperfect Competition

Overview of the Model and of the Results
Rational Expectation Equilibrium with Imperfect Competition 1/2

This paper model the setting as a simultaneous incomplete

information (Bayesian) game ; the rational expectation
equilibrium is then the B.N.E. of this game
Three kind of traders: informed and uninformed speculator,
and noise traders trading randomly
Speculators are imperfect competitors E.U. maximizers;
after their signal, they choose a demand function, taking as
given others’ strategies
Since the clearing price is determined after the choice of
traders, speculators know that they are influencing the
price
Each speculator acts like a monopolist, having the
strategic incentive to reduce traded quantities in
comparison with competitive levels

Andrea Gallo Informed Speculation with Imperfect Competition

Overview of the Model and of the Results
Rational Expectation Equilibrium with Imperfect Competition 2/2

Here there exist an equilibrium even with risk neutral

agents, and the incentive to acquire private information
does not disappear
As noise trading → 0, profits from private information → 0
At the limit with many speculators, this model converges to
a monopolistic competition one (each agent has small
influence on prices)
In this case, the equilibrium outcome coincides with that of
Hellwig’s large market model

Andrea Gallo Informed Speculation with Imperfect Competition

Structure and Notation

One period only; single risky asset traded at market

e; exogenous liquidation value ve, so that
clearing price p
e
returns are ve − p

Noise traders trade the exogenous random quantity ze

N informed speculators. Each one observes a private

signal in and selects a strategy (demand schedule)
xn = Xn (p, in )

M uninformed speculators; ym = Ym (p)

Andrea Gallo Informed Speculation with Imperfect Competition

Structure and Notation
Special Assumptions 1/2

The following assumption are needed for analytical tractability

Informed speculators have exponential utility with risk
aversion coefficient ρI ; uninformed speculator the same
with coefficient ρU ; 0 initial endowment for both

Un (πIn ) = −exp(−ρI πIn ); Vn (πUm ) = −exp(−ρU πUm ),

where πIn = (v − p)xn and πUm = (v − p)ym

Note that if the risk aversion coefficient are zero,

speculators are risk neutral

Andrea Gallo Informed Speculation with Imperfect Competition

Structure and Notation
Special Assumptions 2/2

Moreover, we assume the following about private information of

informed speculators:

The signal to each speculator can be expressed as

ein = ve + e
en , where e
en is a random variable; the N + 2
e are normally and independently
random variables ve, ze, e
distributed with zero mean and variance

var (ve) = τv−1 , var (ze) = σz2 , en ) = τe−1

var (e

The fact that noise is independent from private information

reflects the fact that it has no information content;
moreover, different informed speculators have different
private information, since the e e are independent

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectations Equilibrium with Imperfect
Competition
Toward a Definition 1/2

Difficult to define: how do we model the dependency of prices

on strategies?
Recall that competitive R.E.E. is a random variable p e
together with a strategy profile such that market clears and
e, i.e.
the strategy profile is a Nash Equilibrium given p

e, ein ))} ≥ E{Un ((ve − p

e)Xn (p
E{Un ((ve − p e, ein ))}
e)Xn0 (p

e)Ym (p
E{Vm ((ve − p e)Ym0 (p
e))} ≥ E{Vm ((ve − p e))}
No need to specify how equilibrium price is determined
and no way to understand the mechanism incorporating
information into prices

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectations Equilibrium with Imperfect
Competition
Toward a Definition 2/2

In this model we have to specify the market microstructure

rule leading to price formation
Crucial point, since this rule influences the demand
schedule of each player, and thus shapes the strategic
incentives of the game
Market clearing rule: A demand schedule Xn (∙, in ) is a
correspondence mapping prices into non-empty subsets of
[−∞, +∞]. This allows for different kind of orders: traders
can submit market orders, limit orders (and any convex
combination)
Then, an auctioneer computes the set of clearing prices
and quantities. She picks the lower clearing price and the
associated quantity minimizing the sum of squared
quantities traded by speculators
Andrea Gallo Informed Speculation with Imperfect Competition
Rational Expectations Equilibrium with Imperfect
Competition
Definition and Comparison with Perfect Competition 1/3

Definition of equilibrium
1 For all n = 1, . . . , N and for any alternative vector of
strategies X 0 differing from X only in the nth component
Xn , the strategy X yields a utility level no less than X 0 :

e(X 0 , Y ))xen (X 0 , Y ))}

e(X , Y ))xen (X , Y ))} ≥ E{Un ((ve−p
E{Un ((ve−p

2 For all m = 1, . . . , M and for any alternative vector of

stategies Y 0 differing from Y only in the mth component
Ym , the strategy Y yields a utility level no less than Y 0 :

e(X , Y 0 ))yem (X , Y 0 ))}

e(X , Y ))yem (X , Y ))} ≥ E{Vm ((ve−p
E{Vm ((ve−p

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectations Equilibrium with Imperfect
Competition
Definition and Comparison with Perfect Competition 2/3

Let’s reframe the definition of competitive equilibrium in

order to compare it with the previous definition
A competitive rational expectations equilibrium is a
strategy profile (X , Y ) such that

e(X , Y ))xen (X 0 , Y ))}

e(X , Y ))xen (X , Y ))} ≥ E{Un ((ve−p
E{Un ((ve−p

and
e(X , Y ))yem (X , Y 0 ))}
e(X , Y ))yem (X , Y ))} ≥ E{Vm ((ve−p
E{Vm ((ve−p

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectations Equilibrium with Imperfect
Competition
Definition and Comparison with Perfect Competition 3/3

Note that this differs from the competitive equilibrium

definition given before in the fact that it incorporates the
requirement that the clearing price is determined by the
market clearing rule
It differs from the imperfect competition definition in the fact
that speculators ignore their effect on prices
(schizophrenia)

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectations Equilibrium with Imperfect
Competition
Maximizing against a Residual Supply Curve

Let each informed speculator act as a monopsonist against

eIn + λI xn
a residual supply curve p = p
In the following lemma, assume peIn , ve, and ein are jointly
normally distributed. Let k1 , k2 , k3 and τ ∗ be constants
defined by

eIn , ein } = k1 p
E{ve|p eIn + k2ein + k3

eIn , ein } = τ ∗
var −1 {ve|p
Lemma 5.1 Consider the monopolist’s modified problem of
maximizing against a linear supply schedule
p=p eIn + λ1 xn . Let xn∗ denote the maximizing quantity and
∗
p the maximizing price

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectations Equilibrium with Imperfect
Competition

Case 1. Assume the second-order condition

eIn , ein } > 0 holds. Then there is a unique
2λI + ρI var {ve|p
solution implementable after announcing a unique demand
schedule whose graph is a straight line which determines a
unique price by intersecting the residual supply curve.
Case 2. Assume SOC < 0. Then the monopolist attains
infinite utility by trading infinite quantities.
Case 3. Assume SOC = 0. Then the monopolist attains
infinite utility by trading infinite quantities if
E{ve|peIn , ein } 6= ρIn , and the monopolist is indifferent to the
quantity he trades if E{ve|p eIn , ein } = ρIn .

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectation Equilibrium with Imperfect
Competition

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectations Equilibrium with Imperfect
Competition

We will arrive at characterizing a symmetric linear

equilibrium in terms of parameters to which we can attach
an intuitive interpretation
Let ζ be the informational incidence parameter, defined as

ζ = τe−1 τI βλ.

This parameter measures the number of dollars by which

the market price goes up as the signal of the nth
speculator goes up by one dollar

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectations Equilibrium with Imperfect
Competition

Let ξI and ξU be defined as follows:

ξI = γI λ, ξU = γU λ, with NξI + Mξ2 = 1

The first parameter measures marginal market share of the
quantity traded by noise traders: as the realization z goes
up by λ dollars, the quantity traded by informed
speculators goes up by ξI units

The second parameter is analogously interpreted as the

marginal market share for uninformed speculators

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectations Equilibrium with Imperfect
Competition

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectations Equilibrium with Imperfect
Competition
Characterization of the Symmetric Equilibrium

Theorem 5.2 The symmetric equilibrium with imperfect

competition is characterized by the solution to the following
three equations, and additional inequalities:

(1 − ϕI )(1 − ξI ) = 1 − ζ

ρI β (1 − ϕI )(1 − 2ζ)
=
τe 1−ζ
ξU ξτU ξ ρ βτ
+ U U I = ζτU − ϕU τI
1 − ξU τe
1 ϕU 1 1 − ϕU
β > 0, 0<ξ6 , < ξI < , 0 < ξU <
2 N N M

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectations Equilibrium with Imperfect
Competition
Informativeness of Prices 1/2

In the equilibrium with imperfect competition, the

informational efficiency parameter ϕ1 is lower than in the
case with perfect competition

This means that prices with imperfect competition are less

informative than prices with perfect competition!

Intuition: when informed traders realize that they trade

against upward sloping residual supply curves, they restrict
quantities thus reducing elasticity with respect to private
information

This leads to prices being less informative!

Andrea Gallo Informed Speculation with Imperfect Competition

Rational Expectations Equilibrium with Imperfext
Competition
Informativeness of Prices 2/2

In particular, how much information is revealed depends

upon the value of ζ

When ζ is close to 0, there is not much difference between

perfect and imperfect competition equilibrium

When ζ approaches is upper bound of 1/2, the

monopolistic behavior of informed traders makes a huge
difference

With imperfect competition prices never reveal more than

half the private information of informed speculators

Note how this contrasts sharply with the prediction of the

model with perfect competition!
Andrea Gallo Informed Speculation with Imperfect Competition
Conclusion

By modelling informed traders as imperfect competitors

that strategically restrict their traded quantities, this paper
makes it possibile to avoid the schizophrenia problem of
competitive rational expectations equilibrium
Moreover, this allows for a more sensible analysis of how
individual strategic incentives shape market prices in
markets affected by information asymmetry
In particular,risk neutral traders respond to incentives in
the way introspection would suggest
In fact, with imperfect competition traders keep prices
inefficient enough to encourage traders to purchase costly
private information

Andrea Gallo Informed Speculation with Imperfect Competition