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Middlemen versus Market Makers: A Theory of Competitive Exchange

We 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 only be obtained through a costly search process. We consider an initial equilibrium where 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 post-entry 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. We show that strict Pareto improvements occur even in cases where the market maker's entry drives all middlemen out of business, monopolizing the intermediation of trade in the market.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8883.

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Date of creation: Apr 2002
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Publication status: published as Rust, John and George Hall. "Middlemen Versus Market Makers: A Theory Of Competitive Exchange," Journal of Political Economy, 2003, v111(2,Apr), 353-403.
Handle: RePEc:nbr:nberwo:8883
Note: IO
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  1. Michael J. Fleming, 2001. "Measuring treasury market liquidity," Staff Reports 133, Federal Reserve Bank of New York.
  2. George Hall and John Rust, Yale University, 2001. "Econometric Methods for Endogenously Sampled Time Series: The Case of Commodity Price Speculation in the Steel Market," Computing in Economics and Finance 2001 274, Society for Computational Economics.
  3. Yannis Bakos, 2001. "The Emerging Landscape for Retail E-Commerce," Journal of Economic Perspectives, American Economic Association, vol. 15(1), pages 69-80, Winter.
  4. 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.
  5. Yavas, Abdullah, 1992. "Marketmakers versus matchmakers," Journal of Financial Intermediation, Elsevier, vol. 2(1), pages 33-58, March.
  6. Thomas Gehrig, 1993. "Intermediation in Search Markets," Discussion Papers 1058, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  7. Daniel F. Spulber, 1996. "Market Microstructure and Intermediation," Journal of Economic Perspectives, American Economic Association, vol. 10(3), pages 135-152, Summer.
  8. Spulber, Daniel F, 1996. "Market Making by Price-Setting Firms," Review of Economic Studies, Wiley Blackwell, vol. 63(4), pages 559-80, October.
  9. 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.
  10. repec:cup:cbooks:9780521736602 is not listed on IDEAS
  11. Hall, George & Rust, John, 2000. "An empirical model of inventory investment by durable commodity intermediaries," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 52(1), pages 171-214, June.
  12. David Lucking-Reiley & Daniel F. Spulber, 2000. "Business-to-Business Electronic Commerce," Vanderbilt University Department of Economics Working Papers 0016, Vanderbilt University Department of Economics.
  13. 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.
  14. Caillaud, Bernard & Jullien, Bruno, 2001. "Chicken and Egg: Competing Matchmakers," CEPR Discussion Papers 2885, C.E.P.R. Discussion Papers.
  15. 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.
  16. Yanelle, Marie-Odile, 1989. "The strategic analysis of intermediation," European Economic Review, Elsevier, vol. 33(2-3), pages 294-301, March.
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