An experiment on the efficiency of bilateral exchange under incomplete markets

Abstract

We test in a controlled laboratory environment whether traders in a bilateral exchange internalize the impact of their actions on market prices better than in a large market. In this model, traders choose asset holdings, constrained by a technology frontier. Next, each trader experiences a random shock which makes only one type of asset profitable. In a general equilibrium environment with incomplete markets, this leads to pecuniary externalities because traders increase scarce asset holdings beyond what is socially optimal. This behavior is especially exacerbated in large experimental markets as traders fail to internalize the impact of their actions on prices. We find that when markets are incomplete, a bilateral exchange can slightly mitigate the extent of pecuniary externalities, and weakly increase welfare.