Competition And Equilibrium Spreads

A single market maker quoting alone can set the bid-ask spread wide enough to comfortably cover both its costs (inventory risk, order-processing costs, and losses to better-informed traders) and its desired profit margin. Once a second market maker starts quoting the same instrument, each is racing to be at or near the best bid and offer to capture order flow, and the natural competitive response is to narrow spreads to attract that flow away from the rival — a dynamic that continues as more competitors enter.

This narrowing doesn't go on forever, though. As competition drives quoted spreads down toward the market maker's true underlying costs, further tightening becomes unprofitable: a spread narrower than the sum of adverse-selection losses, inventory risk, and processing costs simply loses money on average, so rational market makers stop competing on price at that floor. In practice this means spreads compress quickly when a market goes from one or two liquidity providers to several, but the marginal benefit of adding still more competitors beyond that point is much smaller.

A stock that trades on a single exchange with one designated market maker might show a 5-cent spread; once the same stock is quotable across several competing venues and market makers, the spread might compress to 1-2 cents — but rarely to zero, because adverse selection and inventory risk are real costs that persist regardless of how many competitors are quoting.