Asymmetric Information, Endogenous Illiquidity, and Asset Pricing With Imperfect Competition∗

We use a novel framework that integrates standard asset pricing and microstructure models to study how asymmetric information, imperfect competition among market makers, and risk aversion affect equilibrium illiquidity and asset pricing. All the main results are obtained in closed-form. In our model, market power, asymmetric information, and market-making cost drive market illiquidity. This model can potentially explain some of the puzzling empirical findings such as (1) the bid-ask spread can be lower with asymmetric information; (2) the bid-ask spread can be positively correlated with trading volume; (3) stock volatility tends to decrease trading volume; (4) the bid-ask spread is positively correlated with market makers’ inventory; (5) trading volume may increase with information asymmetry. In addition, we find that information asymmetry may reduce the welfare loss due to market power. Furthermore, the equilibrium number of market makers decreases with the market-making cost and increases with trading volume, and may increase with information asymmetry. JEL Classification Codes: D42, D53, D82, G12, G18.