Market Microstructure and Intermediation

1. Market Microstructureand Intermediation

2. Three Basic Questions • three basic questions in the classical economics: • what shall be produced • how shall it be produced • for whom

3. The Fourth Question • Stiglitz(1994): How should these decisions be made, and who should make them?

4. 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

5. What Is Intermediary? (I) • An intermediary is an economic agent that • purchases from suppliers for resale to buyers Interme diary buyers suppliers purchase resale

6. What Is Intermediary? (II) • or, helps sellers and buyers meet and transact Interme diary buyers sellers

7. 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

8. Why should the intermediation be paid more attention to?

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

10. 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.

11. Price Setting and Market Clearing • In a perfectly competitive market, firms are only price-takers

12. 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

13. 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

14. The Bid-Ask Spread and the Supply and Demand Model p, w S(w) p* pw w* D(p) Q Q* Qw

15. How the firm adjusts prices to clear market? p, w S(w) p* pw w* D’(p) D(p) Q Q* Qw

16. Providing Liquidity and Immediacy • The problem of double coincidence of wants commodities • Supplier • Customer cash

17. Providing Liquidity and Immediacy • How intermediaries provide liquidity commodities inventory • Customer • Supplier Intermediary cash money

18. How Intermediaries adjust price to maintain inventories and cash? p, w S(w) p* w* D(p) Q* X Q

19. Matching and Searching • Matching • Without intermediaries: decentralized exchange fashion, more risky option • With intermediaries: centralized exchange fashion, trade at a known price

20. 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

21. Guaranteeing and Monitoring • Asymmetric information

22. Guaranteeing and Monitoring: Used Car Case

23. Guaranteeing and Monitoring: Used Car Case • Without intermediaries, buyer 1 will pay $150

24. Guaranteeing and Monitoring: Used Car Case • With intermediaries, intermediaries directly

25. Guaranteeing and Monitoring • Delegated Monitoring • Example: financial intermediation

26. Conclusion • Intermediaries provide the underlying microstructure of most markets.

27. 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?

28. Our Group Member • Chen Binglin • Chen Guojun • Gao Jin • Pan Xuejia • Yang Han

29. Thank You! • Any questions or comments are welcome!