Market Microstructure

and Intermediation

Three Basic Questions

three basic questions in the classical economics:

• what shall be produced

• how shall it be produced

• for whom

The Fourth Question

Stiglitz(1994):

How should these decisions be made, and who should make them?

Answer to the Fourth Question

Firms decide what, how and for whom

Firms create and manage markets between buyers and sellers by acting as intermediaries

What Is Intermediary? (I)

An intermediary is an economic agent that• purchases from suppliers for resale to buyers

Intermediary

resalepurchasesuppliers buyers

What Is Intermediary? (II)

• or, helps sellers and buyers meet and transact

Intermediary

sellers buyers

What is Microstructure?

In finance, the study of intermediation and the institutions of exchanged is called market microstructure

we apply this term to markets in general

Why should the intermediation be paid more attention to?

In the U.S. economy, they comprise over a quarter of GDP

Intermediaries have these four most important functions:

• setting prices and clearing markets

• providing liquidity and immediacy

• coordinating buyers and sellers in matching and searching

• guaranteeing quality and monitoring performance

Our purpose is to develop these four functions from now on.

Price Setting and Market Clearing

In a perfectly competitive market, firms are only price-takers

Price Setting and Market Clearing

In reality, many firms have some market power to adjust prices, due to

• product differentiation, transportation costs, consumer switching costs, transaction cost, barriers to entry, incomplete price, and so on

Price Setting and Market Clearing

Consider an intermediary that has market power in both its customer and supplier markets

This intermediary thus has some power to set both bid and ask prices

The Bid-Ask Spread and the Supply and Demand Model

Q* Qw

D(p)

S(w)p*

w*

pw

p, w

Q

How the firm adjusts prices to clear market?

Q* Qw

D(p)

S(w)p*

w*

pw

p, w

Q

D’(p)

Providing Liquidity and Immediacy

The problem of double coincidence of wants

•Customer•Supplier

commodities

cash

Providing Liquidity and Immediacy

How intermediaries provide liquidity

•Customer•Supplier Intermediary

commodities inventory

cash money

How Intermediaries adjust price to maintain inventories and cash?

Q* X

D(p)

S(w)p*

w*

p, w

Q

Matching and Searching

Matching• Without intermediaries: decentralized

exchange fashion, more risky option

• With intermediaries: centralized exchange fashion, trade at a known price

Matching and Searching

Searching• Searching costs

• Transportation cost

• Communicating cost

• Time cost and discount rate

• Intermediaries can reduced those cost by creating centralized exchange fashion

Guaranteeing and Monitoring

Asymmetric information

Guaranteeing and Monitoring: Used Car Case

High-quality car Low-quality car

$200 $100

Potential buyer 1 Potential buyer 2

$220 $130

Guaranteeing and Monitoring: Used Car Case

Without intermediaries, buyer 1 will pay $150

High-quality car Low-quality car

quit $150

Potential buyer 1 Potential buyer 2

Pay $150($-50) quit

Guaranteeing and Monitoring: Used Car Case

With intermediaries,

High-quality car Low-quality car

$200 $100

Potential buyer 1 Potential buyer 2

$220 $130

intermediaries directly

Guaranteeing and Monitoring

Delegated Monitoring• Example: financial intermediation

Conclusion

Intermediaries provide the underlying microstructure of most markets.

Our Question

1. How will an intermediary adjust its bid-ask price when the demand it faces shift up? (Suppose this intermediary has market power to set prices on both sides)

2. What’s the transaction in the used car case with and without intermediary?

Our Group Member

Chen Binglin Chen Guojun Gao Jin Pan Xuejia Yang Han

Thank You!

Any questions or comments are welcome!