Price experimentation and security market structure

We examine the role of market makers in facilitating price discovery.We show that a specialist may experiment with prices to inducemore informative order flow. thereby expediting price discovery.Market makers in a multiple-dealer system, unlike a specialistsystem, do not have the incentives to perform such costly experimentsbecause of free-rider problems. Consequently, the specialistsystem may provide open markets where competition fails butat the cost of wider bid-ask spreads. We analyze the effectof experimentation on the bid-ask spread and provide an exploratoryanalysis of intraday specialist data that is consistent withour price experimentation hypothesis.