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In this paper, we study the relationship between the market structure in the real sector and the effects of insider trading. We find that the market structure in the real sector matters. When the monopolist insider chooses the price of the real good rather than the output, insider trading increases the price rather than the quantity. When the insider competes with another firm in the real sector, and chooses quantity, the output increases due to insider trading but by less than in monopoly models. In addition, the stock price is more informative than in monopoly models.

The debate on the effect, as well as the value, of trading on financial markets by agents who have inside information has a long history. Much of the debate has centered on two issues. The first is fairness: should an individual who has inside information about the activities of a firm be able to trade on that information at the expense of individuals without that information? The second deals with the dissemination of information. For efficient markets it is necessary that all information be disseminated and then evaluated by all agents. It is argued that the role of the insider is to help disseminate information and therefore the gain of the insider is merely a payoff to releasing this private information. Indeed, this informational effect is precisely what has been captured by Kyle (1985) in his seminal work on insider trading. However, there is another effect of insider trading, namely, the relationship between the financial decisions made by the insider and the ‘real’ activities of the firm. In particular, the insider’s ability to make real decisions affects the financial markets just as insider trading affects the real output and the price of the good. The question of the relationship between the real and financial effects of insider trading has been studied recently in Jain and Mirman (2000) (henceforth, JM) in the context of Kyle’s model of insider trading. In Kyle’s model, the insider is assumed to know the value of the firm (which is drawn from a normal distribution) but has no effect on the decisions of the firm. In JM, the insider is modeled as a manager, as well as a trader in the stock, of the firm. In this way, the manager can influence the real decisions of the firm changing the value of the firm in the financial markets, while maximizing his own profits on the financial market. This manipulation has an effect on the firm’ profit and thus on its ‘real’ value. The market valuation of the firm is determined by a perfectly competitive market maker, who in Kyle’s model sees only the order flow of the insider and the noise traders. However, in JM, the market maker also sees other sources of information, for example, the firm’s price in the real sector may be public information and contain valuable signals for pricing the stock. In JM, the insider is a quantity-setting monopolist and sets a quantity higher (and average price lower) than would a monopolist without insider trading. Despite the fact that there is an important relationship between real and financial market variables in JM, the result that output is higher due to insider trading must be interpreted carefully. In JM, there is an important relationship between the ‘real’ signal (a price observation in JM) and the incentive for the firm to produce more in order to signal a lower value of the firm and therefore a lower stock price, enabling the insider to make higher profits. Indeed, it is the purpose of this paper to show that the market structure and the ‘real’ signal observed by the market maker are important in determining the real and financial effects of insider trading. We refine the results obtained in JM by examining the role of the market structure in the real sector. In particular, we show that the real effect of insider trading is sensitive to the type of market structure in which the firm operates and the signals available to the market maker from the real sector. We also show that increased competition in the real sector (for example, duopoly) changes the stock pricing function significantly and makes the stock price even more informative than in the monopoly models (of Kyle and JM). Finally, the increased information release has the effect of lowering the profits of the insider compared to JM and models in which the market maker sees only the total order flow (henceforth, the Kyle-type models). The comparison with JM is interesting since it implies that the competition in real sector leads to lower profits from the financial sector, thus emphasizing the informational link between the two sectors. The comparison with Kyle-type models reinforces the result in JM that the insider’s inability to manipulate the signal from the real sector leads to a higher information revelation and lower profits. In this paper, we present two models of insider trading based on two different market structures in the real sector. The purpose is to study the effect of market structure on how insider trading affects the real as well as the financial variables. In the first model, the insider is the manager of the firm whose stock he trades. As manager, he chooses the price of the real good that the firm produces, rather than the output as in JM. The firm is assumed to be monopolistic. In the financial market, the market maker sets the price of the stock based on the prior distribution of the value of the firm as well as two signals that he observes. One signal is provided by the total stock order flow, made up of the manager’s order and the noise trade. The other signal is observed in the real sector, which is a noisy observation of the quantity produced by the manager. This is in contrast to JM where the real sector signal is a noisy observation of the price of the real good. We find that the average equilibrium output is lower and the price of the real good higher, a result opposite to JM. Thus it matters what the monopolist chooses and what the market maker sees and thus the welfare implications are to be drawn depending on the market structure and the informational structure.1 In the second model, the firm, managed by the insider, competes with another firm in the real sector and the insider chooses the quantity to be produced. Thus there is Cournot duopoly in the real sector. The market maker observes the total order flow and a noisy market price of the real good as in JM. Interestingly, we find that the competition in the real sector influences the equilibrium values of the variables in the financial market. Specifically, the stock pricing function is different in Cournot duopoly in the real sector compared to the monopoly models. However, the amount of insider trading remains unchanged. The informativeness of the stock price is higher under Cournot duopoly than in either Kyle or JM. Finally, profits of the insider are lower compared to JM and a Kyle-type model in which the market maker only observes the total order flow. Thus the market structure in the real sector affects the outcomes in the financial sector and the profits of the insider that are derived from trading in the financial markets. This result is similar in spirit to the results of Eaton-Mirman (1991) and Jain-Mirman (2001) in which segmented markets are related through the process of information gathering. Most of the theoretical literature on insider trading, until recently, focuses on the financial market only. Some recent work (See Dow and Rahi (1997), Leland (1992) and Manove (1989)2) incorporates real as well as financial sectors in their models of insider trading. However, these papers are more interested in the issue of fairness than in the question of the relationship between the real and financial variables due to insider trading. In particular, the role of the insider in making real decisions and thus leading to an interdependence between the real and financial decisions has not been analyzed. The rest of the paper is organized as follows: in Section 2, we present the price-choosing monopolist model of insider trading; in Section 3, we present the Cournot duopoly model; we conclude in Section 4.

In this paper, we have shown that the market structure in the real sector matters in how insider trading affects the informativeness of the stock price as well as the real variables. Market structure in the real sector also has significant effects on the formation of stock prices and the level of insider profits. These effects are important ingredients in determining the social desirability of insider trading.