Inefficiencies in Networked Markets

Abstract

In many markets, relationship specific investments are necessary for trade. These formed relationships constitute a networked market in which not all buyers can trade with all sellers. We show that networked markets can be decomposed to identify how alternative trading opportunities affect who trades with whom and at what price. This uncovers agents’ investment incentives. In some markets a buyer and seller must make different, separate investments to trade, while in others investments are jointly negotiated. Either way, inefficiencies can be severe and consume all the gains from trade, but for different reasons. We consider three applications in detail: high-skill labor markets, merger markets when industries are consolidating, and the international market for natural gas.

Keywords: Networked markets, network formation, network bargaining, matching, outside option, inefficient investment, relationship-specific investment, hold up