Middlemen versus Market Makers: A Theory of Competitive Exchange
AbstractWe present a model in which the microstructure of trade in a commodity or asset is endogenously determined. Producers and consumers of a commodity (or buyers and sellers of an asset) who wish to trade can choose between two competing types of intermediaries: "middlemen" (dealer/brokers) and "market makers" (specialists). Market makers post publicly observable bid and ask prices, whereas the prices quoted by different middlemen are private information that can be obtained only through a costly search process. We consider an initial equilibrium with which there are no market makers but there is free entry of middlemen with heterogeneous transactions costs. We characterize conditions under which entry of a single market maker can be profitable even though it is common knowledge that all surviving middlemen will undercut the market maker's publicly posted bid and ask prices in the postentry equilibrium. The market maker's entry induces the surviving middlemen to reduce their bid-ask spreads, and as a result, all producers and consumers who choose to participate in the market enjoy a strict increase in their expected gains from trade. When there is free entry into market making and search and transactions costs tend to zero, bid-ask spreads of all market makers and middlemen are forced to zero, and a fully efficient Walrasian equilibrium outcome emerges.
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Bibliographic InfoArticle provided by University of Chicago Press in its journal Journal of Political Economy.
Volume (Year): 111 (2003)
Issue (Month): 2 (April)
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Web page: http://www.journals.uchicago.edu/JPE/
Other versions of this item:
- John Rust & George Hall, 2001. "Middle Men Versus Market Makers: A Theory of Competitive Exchange," Cowles Foundation Discussion Papers 1299, Cowles Foundation for Research in Economics, Yale University.
- John Rust & George Hall, 2002. "Middlemen versus Market Makers: A Theory of Competitive Exchange," NBER Working Papers 8883, National Bureau of Economic Research, Inc.
- D4 - Microeconomics - - Market Structure and Pricing
- D5 - Microeconomics - - General Equilibrium and Disequilibrium
- D6 - Microeconomics - - Welfare Economics
- G2 - Financial Economics - - Financial Institutions and Services
- L1 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance
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