Abstract
This paper presents a model of price formation in competitive capital markets. Liquidity providers supply liquidity, liquidity consumers trade against it, and competition imposes zero expected profits on liquidity providers. This implies that the expected future price must equal the average execution price, so permanent price impact is determined by the liquidity supply consumed by the trade. Aggregating price impacts yields testable relationships linking prices, liquidity, trading volume, and volatility. Using NYSE Daily TAQ data for U.S. common stocks from September 2003 to December 2024, I estimate the shape of liquidity supply and test the resulting relationships. The estimates support a quadratic liquidity supply, implying square-root price impact at the level of individual trades. The empirical relationships are very close to those predicted by the model.
