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Middle Men Versus Market Makers: A Theory of Competitive Exchange

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Abstract

What determines how trade in a commodity is divided between privately negotiated transactions via "middle men" (dealer/brokers) in a telephone or "dealer market" versus transactions via "market makers" (specialists) at publicly observable bid/ask prices? To address this question, we extend Spulber's (1996a) search model with buyers, sellers, and price setting dealers to include a fourth type of agent, market makers. The result is a model where market microstructure -- the division of trade between dealers and market makers -- is determined endogenously. In Spulber's model, dealers are the exclusive avenue of exchange, and prices are private in the sense that price quotes can only be obtained through direct contact (e.g. telephone calls) to individual dealers. In contrast a market maker can be conceptualized as operating an exchange that posts publicly observable bid and ask prices. In our model buyers and sellers can either trade with the market maker at the publicly posted bid/ask price or they can search for a better price in the dealer market. We show that the entry of a monopolist market maker can be profitable if it has a lower marginal cost of processing transactions than the least efficient middle man in the equilibrium without market makers. If this is the case the entry of a market maker segments the market; the highest valuation buyers and the lowest cost sellers trade with the market maker and the residual set of intermediate valuation buyers and sellers search for better prices in the dealer market. Dealers act as a "competitive fringe" that undercut the bid/ask spread charged by the monopolist market maker. However less efficient dealers are driven out of business. The remaining dealers are still profitable although the entry of a monopolist market maker significantly reduces their profits and bid-ask spreads. Thus, entry by a marker maker results in uniformly higher surpluses for buyers and sellers and higher trading volumes. When there is free entry into market making and market makers' marginal costs of processing transactions tend to zero, bid-ask spreads converge to zero and a fully efficient Walrasian equilibrium outcome emerges.

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Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1299.

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Length: 48 pages
Date of creation: Apr 2001
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Publication status: Published in Journal of Political Economy (April 2003), 111(2): 353-403
Handle: RePEc:cwl:cwldpp:1299

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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

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Keywords: Middle men; intermediation; market makers; search; market microstructure; bid-ask spread; Walrasian equilibrium;

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  1. Yannis Bakos, 2001. "The Emerging Landscape for Retail E-Commerce," Journal of Economic Perspectives, American Economic Association, vol. 15(1), pages 69-80, Winter.
  2. George Hall & John Rust, 2002. "Econometric Methods for Endogenously Sampled Time Series: The Case of Commodity Price Speculation in the Steel Market," NBER Technical Working Papers 0278, National Bureau of Economic Research, Inc.
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  4. David Lucking-Reiley & Daniel F. Spulber, 2001. "Business-to-Business Electronic Commerce," Journal of Economic Perspectives, American Economic Association, vol. 15(1), pages 55-68, Winter.
  5. George Hall & John Rust, 2007. "The (S,s) Policy is an Optimal Trading Strategy in a Class of Commodity Price Speculation Problems," Economic Theory, Springer, vol. 30(3), pages 515-538, March.
  6. Spulber,Daniel F., 2009. "The Theory of the Firm," Cambridge Books, Cambridge University Press, number 9780521736602, April.
  7. Battalio, Robert & Greene, Jason & Jennings, Robert, 1997. "Do Competing Specialists and Preferencing Dealers Affect Market Quality?," Review of Financial Studies, Society for Financial Studies, vol. 10(4), pages 969-93.
  8. Yavas, Abdullah, 1992. "Marketmakers versus matchmakers," Journal of Financial Intermediation, Elsevier, vol. 2(1), pages 33-58, March.
  9. O'Hara, Maureen & Oldfield, George S., 1986. "The Microeconomics of Market Making," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(04), pages 361-376, December.
  10. Michael R. Baye & John Morgan, 2001. "Information Gatekeepers on the Internet and the Competitiveness of Homogeneous Product Markets," American Economic Review, American Economic Association, vol. 91(3), pages 454-474, June.
  11. Caillaud, Bernard & Jullien, Bruno, 2001. "Chicken and Egg: Competing Matchmakers," CEPR Discussion Papers 2885, C.E.P.R. Discussion Papers.
  12. George Hall & John Rust, 1999. "An Empirical Model of Inventory Investment by Durable Commodity Intermediaries," Macroeconomics 9904005, EconWPA.
  13. Michael J. Fleming, 2001. "Measuring treasury market liquidity," Staff Reports 133, Federal Reserve Bank of New York.
  14. Gehrig, Thomas, 1993. "Intermediation in Search Markets," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 2(1), pages 97-120, Spring.
  15. Spulber, Daniel F, 1996. "Market Making by Price-Setting Firms," Review of Economic Studies, Wiley Blackwell, vol. 63(4), pages 559-80, October.
  16. Daniel F. Spulber, 1996. "Market Microstructure and Intermediation," Journal of Economic Perspectives, American Economic Association, vol. 10(3), pages 135-152, Summer.
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