Abstract:
This paper uses an experimental electronic market to investigate the effect of
limited attention on the market maker’s ability to provide liquidity and, thus,
on aggregate market liquidity. I find that higher demands on the market
maker’s attention worsen her ability to provide liquidity but do not reduce the
aggregate level of market liquidity. This effect is only significant in less active
markets. Furthermore, the aggregate level of market liquidity remains unaltered
across both highly active and inactive markets, suggesting a reactive
strategy by informed traders who step in to compete with market makers
during high information intensity periods when their attention allocation efforts
are compromised. In fact, in markets with a higher information value,
the effect of attention constraints on the liquidity provision ability of market
makers is greater. This implies that informed traders may not only exploit
their informational advantage against uninformed traders but they may also
use it to reap a higher share of liquidity-based profits. Finally, the market
maker’s trading performance measured by her profit share and ability to
manage her inventory worsens when demands on her attention are greater.
