This paper models the specialist system as a monopolistically competitive market. Demand for the asset is found by solving the investor's portfolio problem with transactions costs. These demand equations are used as inputs in the specialist's price-setting problem. Equilibrium prices and, hence, equilibrium portfolio holdings depend upon the characteristics of the assets and the investors and the number of assets being traded. Conditions are given under which the bid and ask prices will converge to the competitive level as the number of assets increases. Predictive differences between a monopolistically competitive market and a market where specialists collude are also discussed.

Self-regulation is a feature of a number of professions. For example, in the U.S. the government delegates aspects of financial market regulation to self-regulatory organizations (SROs) like the New York Stock Exchange and the National Association of Securities Dealers. We analyse one regulatory task of an SRO, enforcing antifraud rules so agents will not cheat customers. Specifically, we model contracting/enforcement as a two-tier problem. An SRO chooses its enforcement policy: the likelihood that an agent is investigated for fraud and a penalty schedule. Given an enforcement policy, agents compete by offering contracts that maximize customers' expected utility. We assume that the SRO's objective is to maximize the welfare of its members, the agents. We show that the SRO chooses a more lax enforcement policy—meaning less frequent investigations—than what customers would choose. A general conclusion is that control of the enforcement policy governing contracts confers substantial market power to a group of otherwise competitive agents. We also investigate government oversight of the self-regulatory process. The threat of government enforcement leads to more enforcement by the SRO, just enough to pre-empt any government enforcement.