Reputation-based pricing and price improvements in dealership markets

Thierry Foucault and Gabriel Desgranges

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Abstract: Dealers often offer price improvements, relative to posted quotes, to their clients. In this paper, wepropose an explanation to this practice. We also analyze its effects on market liquidity and traders' welfare.Enduring relationships allow dealers to avoid informed trades by offering price improvements to clients who do not trade with the dealer when they are informed. A dealer never observes whether a specific client is informed or not but he can avoid informed orders by conditioning his offers on past trading profits. Cream-skimming of uninformed order-flow increases the risk of informed trading for dealers without a relationship. Thus, authorizing price improvements increases bid-ask spreads and impairs the welfare of investors without a relationship. It may even decrease the welfare of investors who develop a relationship as they sometimes need to trade at posted quotes. The model predicts a positive relationship between (a) the price improvements granted to a specific investor and past trading profits with this investor or (b) the frequency of price improvements and bid-ask spreads

Keywords: Market microstructure; Price improvements; Implicit contracts; Enduring relationships (search for similar items in EconPapers)
Date: 2005
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Citations: View citations in EconPapers (8)

Published in Journal of Economics and Business, 2005, 57 (6), pp.493-527. ⟨10.1016/j.jeconbus.2005.09.001⟩

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Related works:
Working Paper: Reputation-Based Pricing and Price Improvements in Dealership Markets (2012)
Working Paper: Reputation-Based Pricing and Price Improvements in Dealership Markets (2002)
Working Paper: Reputation-based pricing and price improvements in dealership markets (2002)
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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:halshs-00006428

DOI: 10.1016/j.jeconbus.2005.09.001

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