A model of price determination by a market-maker in a dealership market can predict some of the price patterns observed in securities markets. In the authors’ model, observed transaction prices result from the execution of randomly arriving sell and buy orders at the market-maker’s bid and ask prices. These prices are set so as to move the market-maker toward a “preferred” inventory position.
The pair of bid-ask prices set at the preferred inventory position is closest to (in fact, straddles) the “equilibrium” price at which expected supply equals expected demand. The bid-ask spread is minimized at this preferred position; it increases as the market-maker’s inventory diverges from the preferred level.
While the market-maker acts in his own self-interest, the resulting prices possess some desirable characteristics. The quoted prices, as decreasing functions of the market-maker’s inventory position, are stabilizing and moderately changing. Furthermore, the market is efficient, in the sense that traders cannot make a profit without possessing superior information.