TY  - JOUR
AU  - Rust,John
AU  - Hall,George
TI  - Middlemen versus Market Makers: A Theory of Competitive Exchange
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 8883
PY  - 2002
Y2  - April 2002
UR  - http://www.nber.org/papers/w8883
L1  - http://www.nber.org/papers/w8883.pdf
N1  - Author contact info:
John P. Rust
Department of Economics
University of Maryland
3105 Tydings Hall
College Park, MD  20742
Tel: 301/405-3489
Fax: 301/405-3542
E-Mail: jrust@gemini.econ.umd.edu

George Hall
Department of Economics, Mail Stop 21
Brandeis University
 P.O. Box 549110
415 South Street
Waltham, MA 02454-9110
Tel: 781-736-2242
Fax: 781- 736-2269
E-Mail: ghall@brandeis.edu
AB  - 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.
ER  -