This article provides a game theoretic model of price formation and order placement decisions in a dynamic limit order market.
Investors can choose to either post limit orders or submit market orders.
Limit orders result in better execution prices but face a risk of non-execution and a winner's curse problem. Solving for the equilibrium of this dynamic game, closed-form solutions for the order placement strategies are obtained. Thus, testable implications for the cross-sectional behavior of the mix between market and limit orders and trading costs in limit order markets are derived.