Middlemen versus Market Makers: A Theory of Competitive Exchange

John Rust () and George Hall

No 8883, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: D4 D5 (search for similar items in EconPapers)
Date: 2002-04
New Economics Papers: this item is included in nep-fmk and nep-mic
Note: IO
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Citations: View citations in EconPapers (5)

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.

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Journal Article: Middlemen versus Market Makers: A Theory of Competitive Exchange (2003)
Working Paper: Middle Men Versus Market Makers: A Theory of Competitive Exchange (2001)
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