Price Dispersion in a Model with Middlemen and Oligopolistic Market Makers: A Theory and an Application to the North American Natural Gas Market

Abstract

We develop a microstructure model of a market for a homogeneous good in which trade amongst heterogeneous consumers and producers is intermediated by middlemen and oligopolistic market makers (gatekeepers). Market makers post bid and ask prices which are freely observable. Middlemen stand ready to trade at bid and ask prices they quote on a private basis to consumers or producers who identify these intermediaries via a costly search process. We model competition between market makers as a two-stage game: capacity setting in the first stage and bid and ask price setting in the second stage. We characterize the equilibrium market structure of intermediaries and the distribution of prices in equilibrium. Our main focus is the effect on prices that emerges following a change in the market structure of intermediation, specifically through the exit of a market maker. Exit of a market maker initially results in a shift of trade from market makers as a whole to middlemen resulting in an increase in price dispersion. Following transition to the new market structure with fewer market makers, price dispersion returns to its pre-exit level when total trade passing through the remaining market makers is roughly equal to the pre-exit level. We present an empirical study of price dispersion in the North American natural gas market for the period before and following the exit of Enron, a major market maker in late 2001. The empirical evidence supports the main propositions of our theory: price dispersion jumped 4-fold immediately following Enron's exit but returned to its pre-exit level within roughly 2 months following the exit date.