Competition and Collusion in a Dealer Market
Posted: 4 Aug 1999
Date Written: December 1994
This paper develops a game-theoretic model to analyze market makers' intertemporal pricing strategies. Our objective is to understand whether implicit collusion is sustainable in a dealer market where market makers compete on prices. Weanalyze non-cooperative pricing strategies that elevate bid- ask spreads above competitive levels. Such "implicit collusion" differs sharply from the strategies adopted by dealers who cooperate to fix prices. In particular, bid-ask spreads narrow in high volume periods because the incentives for individual dealers to undercut rivals' prices are greater in such cases. In contrast, under pure collusion, spreads increase with volume as dealers cooperate to exploit the greater demand for their market making services. Paradoxically, implicit collusion is harder to sustain in a market dominated by a few dealers than in a market where dealers are equal in size. We demonstrate conditions under which excess spreads can be maintained even with free entry into market making.
JEL Classification: G14
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