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Competition and Collusion in Dealer Markets

Authors

  • PRAJIT K. DUTTA,

  • ANANTH MADHAVAN

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    • Dutta is from the Department of Economics, Columbia University. Madhavan is from the School of Business Administration of the University of Southern California. We thank William Christie, David Easley, Michael Fishman, Larry Harris, Joel Hasbrouck, James Shapiro, and an anonymous referee for their helpful comments. We have also benefitted from the comments of seminar participants at The Ohio State University, the University of Pittsburgh, the JFI Symposium at Northwestern University, the 1995 European Finance Association Meetings, and the 1996 American Finance Association Meetings. Support from National Science Foundation Grant SBR-9410485 (Dutta) is gratefully acknowledged. The comments and opinions expressed in this article are those of the authors alone.


ABSTRACT

This article develops a game-theoretic model to analyze market makers' intertemporal pricing strategies. We show that dealers who adopt noncooperative pricing strategies may set bid-ask spreads above competitive levels. This form of “implicit collusion” differs from explicit collusion, where dealers cooperate to fix prices. Price discreteness or asymmetric information are not required for collusion to occur. Rather, institutional arrangements that restrict access to the order flow are important determinants of the ability to collude because they reduce dealers' incentives to compete on price. Public policy efforts to increase interdealer competition should focus on such restrictions.

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