Article

Experimental Economics

, Volume 4, Issue 1, pp 55-85

First online:

Marketmaking in the Laboratory: Does Competition Matter?

  • Jan Pieter KrahnenAffiliated withFinance Department, Goethe Universitaet FrankfurtCFS Center for Financial Studies, CEPR
  • , Martin WeberAffiliated withLehrstúhl Bankbetiiebs Lehre, Universitaet Mannheim

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Abstract

This paper is the first experimental study of the effects of competition and adverse selection on the performance of market maker (MM-) markets. Information distribution may is either symmetric or heterogeneous. MM-markets are either monopolistic (the specialist markets), or competitive (the multi MM-market). Welfare comparisons are with respect to a continuous double auction (DA-) market. Informed subjects receive an imperfect signal of the true state of the world. We find three main results. First, competition among market makers significantly reduces the bid-ask spread, and increases transaction volume. Second, competition among market makers induces competitive undercutting, yielding net trading losses for market makers as a group in most periods. Third, from the perspective of uninformed traders, a competing MM-regime is optimal, since it minimizes their expected trading losses.

market microstructure dealer market bid-ask spread competition