A simple time-series market microstructure model is constructed within which existing models of spread components are reconciled. We show that existing models fail to decompose the spread into all its components. Two alternative extensions of the simple model are developed to identify all the components of the spread and to estimate the spread at which trades occur. The empirical results support the presence of a large order processing component and smaller, albeit significant, adverse selection and inventory components. The spread components differ significantly according to trade size and are also sensitive to assumptions about the relation between orders and trades. The difference between the ask and the bid quotesthe spread-has long been of interest to traders, regulators, and researchers. While acknowledging that the bid-ask spread must cover the order processing costs incurred by the providers of market liquidity, researchers have focused on two additional costs of market making that must also be reflected in the spread.

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