Working Paper: NBER ID: w8883
Authors: John Rust; George Hall
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.
Keywords: No keywords provided
JEL Codes: D4; D5; D6; D8
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monopolist market maker entry (D42) | Increase in expected gains from trade for all producers and consumers (F10) |
| Monopolist market maker entry (D42) | Reduced bid-ask spreads charged by middlemen (G19) |
| Monopolist market maker entry (D42) | Strict Pareto improvement (D61) |
| Market maker entry can coexist with middlemen (D40) | Depends on transaction costs and intertemporal discount rate (D15) |
| Market maker entry (D40) | Segmentation of the market (D49) |
| Market segmentation (M31) | High-valuation consumers and low-cost producers benefit from trading at publicly posted prices (L11) |