Sunday, February 16, 2003

Middlemen versus Market Makers: A Theory of Competitive Exchange

economics :: business

John Rust, George Hall

NBER Working Paper No. w8883

Issued in April 2002

---- Abstract -----

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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