An experiment on the efficiency of bilateral exchange when markets are incomplete

We test in a controlled laboratory environment whether traders in a bilateral ex- change 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 experimen- tal 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.

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